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Even by the distorted standards of the national housing bubble, north central Florida was a hot market. Between 2004 and 2006 new houses and property markers spread across cow pastures and horse farms, their values soaring so fast that bankers and builders could hardly believe their good timing, or keep up with the workload.

California investment groups would swoop in, order 40 or 60 homes at a pop, then flip them for a quick profit. “It was the Sunbelt’s time. It was stupid,” said Ocala builder Michael J. Kaufman of those heady days. “But was I supposed to say no? We live in a capital gain country.”

Ocala National Bank, like many lenders at the time, had trouble saying no, too. With high demand in its community and a steady flow of easy financing from Wall Street, the small, locally owned bank embarked on a lending binge for real estate and construction. By 2006, its outstanding loans so outweighed its core capital that Ocala National became in effect one of the most risk-prone banks in America.

When the bank finally collapsed last year it cost the federal government’s deposit insurance fund $100 million. That is a tiny fraction of the fallout from big bank failures and bailouts. But the story of Ocala National carries lessons far beyond its size, illustrating how government regulators condoned the speculative behavior of hundreds of smaller banks that helped drive the economy toward a cliff.

As many as 3,000 of the nation’s 8,100 financial institutions are said to be in troubled health, and some analysts expect as many as 250 to fail in the next nine months.

Records and interviews show that federal bank regulators were well aware of Ocala National’s risky lending practices — sometimes meeting with the board where the details were discussed — but failed to act for two years as evidence piled up. The regulators did not use the enforcement tools they had employed years earlier when the bank’s owner and his two sons had been sanctioned for similar behavior.

As the bank sputtered towards doom, regulators also failed to examine flows of millions of dollars from Ocala National to its holding company and to a company owned by the bank owner’s son and five of Ocala’s nine board members, according to a report by the Treasury Department’s inspector general’s office.

The inspector general’s office has found that regulators acted too passively and slowly in many of the 31 recent bank failures it is reviewing.

“We really don’t think the issue is so much an insufficient awareness of bank problems on the part of examiners as much as it is the regulators not taking sufficient and timely action,” Richard K. Delmar, speaking for the inspector general, told The Huffington Post Investigative Fund.

The inspector general’s reviews repeatedly found lapses at Ocala National’s federal overseer — the Office of the Comptroller of the Currency. In five of its six post-mortems of failed banks that had been regulated by the office, the inspector general found “a pattern where OCC examiners spotted the problems early but did not take forceful action until it was too late,” Delmar said.

Among the proposals to remake the government’s financial oversight structure is one by Senate Banking Chairman Christopher Dodd (D-Conn.), which would merge the regulatory functions of the four agencies that supervise banks — OCC, the Office of Thrift Supervision, the Federal Reserve and the Federal Deposit Insurance Corp. The working theory is that consolidation would simplify the system and eliminate agency-shopping by banks that are seeking the most lenient overseer.

The Treasury investigation, however, raises questions about whether consolidation alone would change entrenched attitudes. An unnamed top OCC official who supervised the Ocala National inspection team told the inspector general’s auditors that “he believed there was nothing OCC examiners should have done differently.”

OCC examiners and a supervisor responsible for the bank declined the Investigative Fund’s requests for an interview. In their formal response to the Treasury, OCC officials acknowledged shortcomings in their oversight of Ocala National.

The former owner and executives of Ocala National did not respond to requests to comment for this article. They have said publicly that they did nothing wrong and did not benefit from the flow of money in the bank’s final year to other companies in which they have stakes. The bank only failed, they have said, because of the overall financial crisis.

‘Uncontrolled Growth’

Ocala, population 53,000, is about 90 miles north of Tampa and the business and social hub of Marion County, a prosperous area of five times as many people. The community bank was owned and operated by a well-known family whose patriarch was Don Kay Jr., now 71. One of his sons — Kyle A. Kay, the bank’s vice president — presided over the city council for eight years, where he acquired a reputation for trying to cut taxes and expand retail development.

The bank had been known for its conservative lending practices. But in the late 1990s that began to change. In 1997 and 1998, OCC examiners brought enforcement actions against the bank for what the inspector general’s report described as “uncontrolled loan growth, ineffective management and poor credit administration practices.” In a consent agreement, regulators compelled Ocala to appoint “a capable senior lending officer,” end “any deficiencies in bank management,” stop any lending without analyzing credit information and documenting the value of collateral, and to “obtain current and satisfactory credit information on all loans lacking such information,” among other requirements. The regulator also assessed fines of $5,000 for Don Kay and $2,500 for each of his two sons for “improper insider transactions,” federal bank records show.

Then came the real estate bonanza.

In 2004, the owner handed the reins to his son, Rance Kay, now 39. Under the new chief executive, the bank “aggressively” ramped up its construction and real estate loans, the Treasury inspector general’s review found. Construction loans soared in two years by some 400 percent, to $191 million.

According to the review, between 2005 and 2007 the bank sometimes failed to fully assess the financial condition of borrowers and sometimes failed to get property appraisals. It made loans that were too large given the value of the property involved. Some construction loans equaled the prices builders expected to get when homes eventually sold. The bank grew at such a clip that by June 2006 money flying out the door for construction and land development loans outweighed capital by 694 percent – a concentration in lending unmatched at any other U.S. bank that year.

As fast as the bank could process the loans, investment banks and other middlemen would scoop them up, bundle them as bonds, and sell them to investors. Those were the kind of troubled investments that soured when loans went bad and helped precipitate the financial crisis. “We never thought the secondary market would stop — that that valve would shut off,” said John Plunkett, a member of the bank’s board of directors.

Plunkett’s family business — Triple Crown Homes, one of Ocala’s largest builders — was part of the boom. In 2005 it received an Ocala National loan to build on 125 lots just north of the city in a new development called Citra Highlands.

“In my first board meeting, I thought, ‘You guys are doing great. This is better than building houses,’” Plunkett said. “And there’s no warranty.”

‘Pretty Hunky-Dory’

Where were the bank examiners? They were in the room, but unlike in the 1990s they did not push Ocala National to change its ways. They made recommendations and issued reports to the bank from their examinations – but left it to the bank to decide whether to do anything. And they gave the bank high grades on a report card of its practices and financial health.

Records show that OCC examiners came to inspect Ocala National five times between 2004 and 2007. At times, the federal regulators gathered with the board of directors to discuss the bank’s fiscal health and technology.

“When they met with us,” recalled Plunkett, “it was all pretty hunky dory.”

As early as 2005, the bank’s overseers realized that all but 7 percent of the bank’s loan portfolio was tied up in construction and land development loans. According to the inspector general’s review, the examiners were worried that a downturn in real estate could significantly affect the bank and they recommended that the bank’s board limit its concentration on such loans. Instead, the bank increased lending, deepening its dependence on the real estate bubble that would eventually burst.

By the fall of 2006, Ocala was obviously taking risks beyond overseers’ comfort levels. The OCC placed it on a “watch” list of potentially troubled banks. But the list is internal, kept within the bureaucracy.

Meanwhile, from 2005 to the end of 2007 the OCC continued to assign the bank a grade of “2” — the second-highest possible grade — on an agency report card. The grade, known as a “CAMELS” rating, gauges a bank’s overall health based on such factors as adequacy of capital, quality of assets and sensitivity to market risk on a scale of 1 (best) to 5 (worst). Banks with ratings of 1 or 2 are considered to present few, if any, supervisory concerns. By law, ratings are not disclosed to the public — for fear that low ratings could trigger a run on a bank.

Along with top marks, the OCC merely offered recommendations to Ocala National’s executives — commentary routinely included in inspection reports known formally as “matters requiring attention.”

Then, in 2007, examiners picked up more signs of trouble: Commercial loan officers lacked experience. The bank failed to identify $6 million in problem commercial real estate loans, creating an inaccurate picture of its condition. There was a net operating loss of $2.3 million.

“OCC examiners repeatedly communicated to bank management concerns about rapid loan growth, high concentration in construction and land development loans, and poor credit underwriting and administration,” the inspector general’s report said.

“Despite these concerns, however, OCC did not take strong action to force the bank to correct the problems … A more forceful approach should have been used sooner given the bank’s circumstances,” the review said.

The OCC’s own enforcement policy requires examiners to deal with identified troubles promptly before they worsen or adversely affect a bank’s performance and viability. Among tools at their disposal, besides report cards, are the kind of formal enforcement actions that the regulators imposed on Ocala National in 1997 and 1998. Besides assessing civil money penalties and working out consent agreements, as the OCC did then, regulators can issue directives or seek court orders that would require prompt corrective action.

Another bank action during 2007 caught the attention of the inspector general’s auditors. While incurring an operating loss, the bank paid dividends of $3.9 million to the bank’s holding company, whose majority shareholders included the bank’s owner and his family, and repurchased nonperforming loans held by a company owned by the bank owner’s son and five of the nine members of the bank’s board.

“OCC should have more aggressively examined both of these matters,” the inspector general’s report stated.

Support for the assertion that examiners should have expanded their inquiry appears in the OCC Comptroller’s Handbook — the formal document providing guidance to bank examiners.

“When activities…in a bank, bank subsidiary or other related organization warrant additional attention, examiners should perform appropriate expanded examination procedures,” the handbook states.

Death Spiral

By the time the examiners took some action, in late 2007, it was too late. Amid soaring losses, the OCC worsened the Ocala bank’s report card – to the second-lowest rating, a “4” — and in 2008 took more forceful and decisive steps, imposing requirements to lessen risk and raise capital.

But the problems were too large and severe, and the market staggered downward. The bank was in a financial death spiral. It finally collapsed in January 2009, its bad assets covered by federal deposit insurance and its new owners lessening their acquisition costs by lowering interest rates on customers’ deposits.

Loss to the Federal Deposit Insurance Corp.: $99.6 million. Each time banks are seized, the FDIC acquires whatever assets and liabilities are left and tries to find a purchaser. Customer deposits are secured by a fund that is supported by fees from member banks. With more than 130 bank failures so far this year, the fund has bled into the red, and federal officials now are scrambling to find ways to shore it up. Matthew Anderson, a partner at Oakland-based banking research firm Foresight Analytics, estimates that 3,000 financial institutions are at risk and 250 could fail in the next nine months.

Today the Ocala region is among those struggling through the financial crisis. Empty homes, fallow lots and foreclosures dot the landscape. Of Plunkett’s 125-home subdivision, only 25 actually were built. The rest of Citra Highlands exists only on plat maps.

A spokesman for the current Comptroller of the Currency — John C. Dugan, a 2005 Bush administration appointee retained by President Obama — said Dugan, too, would decline comment beyond an Aug. 25 formal letter responding to the inspector general’s post-mortem of Ocala.

In that letter, Dugan wrote that he agreed “there were shortcomings in our execution of the supervisory process,” and that managers in conference calls would urge examiners to be more thorough and “assertive in identifying and following through on identified weaknesses in a timely manner.”

Dugan also addressed the Treasury report’s concerns about the dividends and payments made by Ocala National, promising that the regulator would “reinforce to our examining staff that it is prudent to expand examination procedures for dividends and related organizations when warranted, particularly when payments may benefit bank management or board members.”

In an October interview with the Ocala Star-Banner, Kyle Kay, 43, the bank’s former vice president and a city councilman, said that the family didn’t benefit from the payment of dividends to the bank’s holding company, ONB Financial Services Inc. He said the money was used by shareholders to pay corporate taxes and to cover the debt service on loans taken by the holding company to support the bank.

His brother and chief executive, Rance Kay, told the newspaper that circumstances beyond his control led to the bank’s failure. “The market turned on us,” he said.

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