The story
Originally a small community bank, Keystone was taken over by banker J Knox McConnell in 1977 at a time when its assets totalled $15-$20 million. McConnell, who died in 1997 before the scandal broke, grew the bank's assets to $85 million in 1990, and then at an ever-faster rate through the 1990s.
By the late 1990s, Keystone's business centred on providing high-loan-to-value home equity loans, including home improvement and debt consolidation loans. It was feted as one of the most profitable small banks in the country and in 1999 it reported assets of $1.1 billion.
To the outside world, the story behind the bank's success seemed to be the sophisticated techniques that McConnell introduced to Keystone from the world of investment banking. From 1993, the small-town bank began to purchase ever-larger volumes of low-quality loans from third parties to repackage into asset-backed securities that could be sold on to investors in the financial markets. By 1999, it had processed some $2.6 billion of loans in nearly 20 major deals.
Keystone was also precocious on the liability side of its balance sheet, where it took advantage of the emerging wholesale deposit market to an unusual degree. This market allowed banks to collect deposits in chunks of millions of dollars from brokers, as opposed to the traditional route of gaining new funds by attracting larger numbers of individual, local depositors.
The FDIC said later that out of a total of $928 million deposited in Keystone accounts in September 1999, about $135 million took the form of traditional insured local deposits (plus around $15 million of local uninsured deposits). The rest were in the form of brokered and non-local (eg, Internet) deposits, attracted by above-market rates of interest offered by the bank.
But if Keystone had turned itself into a credit pipeline to channel asset-backed risk into the investment markets, the pipeline was poorly engineered in terms of board oversight, accounting, documentation and risk management. Indeed, regulators later wondered whether the complex risky loan investment programme had been set up primarily as a 'front' so that certain bank executives could disguise irregular payments to themselves and businesses that they owned.
These payments took the form of 'loan processing' and transaction due diligence fees of various kinds that were not put through the bank's books in the normal manner. Forensic court documents suggest that irregular payments to certain bank officers might have begun at the bank in the McConnell era and then continued after his death, amounting to tens of millions of dollars.
The irregular payments only became apparent after the bank's collapse, but Keystone's risky business strategy attracted regulatory interest through the 1990s. A subsequent report on the regulatory examinations of the bank found that regulators had, since 1992, routinely identified unsafe and unsound practices, regulatory violations and questionable management activities.
By 1997, the OCC had transferred responsibility for reviewing Keystone to a unit that focused on problem banks, and in 1998 the bank was banned from accepting any further brokered deposits. But its relatively complex transactions, and protests from its management, meant that bank examiners never seemed to push quite hard enough to reveal Keystone's true condition until the summer of 1999. (Ironically, bank executives were later to argue that regulatory prejudice was a contributing factor to the bank's failure.)
In the summer of 1999, the FDIC sent in examiners to satisfy itself that the bank was no longer taking brokered deposits. At first, the attention of investigators was drawn to confusing and altered documentation that signalled to them that Keystone was still accepting brokered deposits, contrary to the orders of its regulators. But the inadequacies of Keystone's book-keeping, and stone-walling by bank managers, led to a widening investigation, and examiners discovered by means of 'direct verification with the bank's loan servicers that $515 million in loans carried on the bank's books were not owned by the bank'[2].On 1 September, 1999, horrified regulators closed the bank.
Regulators soon began to suspect that the dubious loans recorded on the bank's books had, in fact, been sold. Court testimony later confirmed that senior bank executives manipulated computer records so that sold assets miraculously appeared back on the books of the bank. (The fact that the bank never received interest payments or other cashflow from these 'virtual' loans should have provided a clear signal that something was wrong.)
Investigators also came to believe that the bank recklessly accepted very poor quality loan assets and inflated the value of assets to mend gaps in its balance sheet. In part, Keystone's business strategy had left it open to attempts to fudge the books. Credit risky 'residual assets' are an inevitable side-effect of bank securitisation programmes. But their value can be very volatile and uncertain, because it depends upon default and prepayment rates that are hard to forecast at the time of the securitisation.
Perhaps the most remarkable aspect of the case was the strenuous attempt by bank officers and employees to obstruct the regulators' investigation in summer 1999. These actions later led to a series of successful prosecutions by federal authorities, in which bank employees co-operating with the authorities recounted how they altered documents and desperately tried to break a microfilm machine in an effort to stop regulators viewing records.
Regulators were also outraged by the "burial of several dump-truck loads of bank documents and microfilm on a ranch owned by one of the officials and her husband"[3]. A search of the ranch by investigators in October 1999 resulted in the recovery of buried bank records that filled 370 file boxes.
Court actions against three of the most senior executives of Keystone bank were complicated by their denial of guilt. Some executives denied even that the bank had lost money, putting the debacle down to a misunderstanding caused by missing records and vengefulness on the part of the authorities.
However, in April 2000, Terry Church, former director and vice-president of the bank, and Michael Graham, one-time executive vice president of Keystone Mortgage Company, a wholly owned subsidiary, were convicted of obstructing bank examiners and later sentenced to more than four years in jail[4].
Following that break-through conviction, first Graham[5], and then eventually Church, pleaded guilty to additional serious charges related to the bank meltdown. They were both given long prison terms, with Church sentenced to serve some 27 years. During her third and final trial in spring 2002, Church told the judge that the bank's securitisation business "became very huge and out of control. We falsified bank records (and) we continued to take money (in fees) even though we weren't supposed to"[6].
In October 2001, Billie Jean Cherry, 77-year old former chairman of the bank (and former mayor of Keystone), was convicted of various counts including fraud and conspiracy, in part stemming from an alleged plot with Terry Church to seize control of millions of dollars in accounts owned by the estate of deceased bank president, J Knox McConnell[7]. Cherry, who had had a 30-year personal relationship with McConnell, said she had believed the money to be hers but was sentenced to 16 years in prison on 28 March 2002.
These senior malefactors dominated the running of the First National Bank of Keystone. Of the bank staff that surrounded them, many were innocent of wrongdoing, but others have since pleaded guilty to various charges of bank examiner obstruction, tax evasion and insider trading of bank stock (when they knew their institution was heading for the rocks).
