As the financial crisis deepened in late 2007 and 2008, the Minnesota Department of Commerce had fewer people spending less time examining the 420 state-chartered banks and credit unions it regulates.
The department has one of the nation's thinnest staffs of bank examiners, with one for every 13 institutions. Missouri, by contrast, has an examiner for every five institutions; Iowa one for every six.
Of the 33 states for which similar numbers are available for credit unions, Minnesota ranks 33rd, with one examiner for every 24 credit unions. Louisiana has one for every seven.
Kevin Murphy, who heads the agency's financial institutions division, disputed the suggestion that more resources would have prevented the state's smaller lenders from using their customer's checking and savings deposits to binge on real estate loans. And while the 63-year-old former federal bank examiner said he was uncomfortable about the level of real estate lending going on, he said the agency can't dictate loan terms to privately held banks.
"If a bank wants to make a loan, I have no authority to prohibit it," he said. "It's their money."
That laissez-faire philosophy has governed regulation of the entire financial sector for much of the past two decades, not just in Minnesota but across the country. It's an industry where, by and large, the companies being regulated pay the salaries of the people who regulate them. There are few limits on the kinds of loans banks and credit unions can make, so examiners may have had little incentive to halt practices that, during the real estate boom, proved extremely lucrative.
"The regulators are to be the little voice in your head that keeps you from doing that which creates perilous risk," said Bloomington bank consultant Jeff Judy. "The current economic situation has shown that the regulators were either unsure of their role, unwilling to accept their role, or unable to execute their role."
At least six different state and federal agencies are charged with monitoring the financial health of Minnesota's lenders, and in many instances those agencies share inspecting duties. So, most share blame for missing problems that now seem obvious.
Jeff Schwalen, CEO of Hiway Federal Credit Union, discovered that first-hand when he combed through $31 million in loans from Fort Snelling Credit Union, which federal regulators sold to him in early 2009 to prevent its collapse.
Schwalen found home equity loans for 50 percent more than a house's value. One couple with a $200,000 mortgage hadn't made a payment for more than two years. Some loans had been made so hastily that no appraisal was done.
These were obvious signs of a lender with judgment clouded by a frenzied real estate market. But they were also evidence, Schwalen said, of lax oversight by the National Credit Union Administration (NCUA), which is charged with regulating the federally chartered credit union.
"I was surprised the regulators would not have seen these problems earlier," he said. "The lack of underwriting standards would have been apparent to anyone with a basic understanding of lending."
In a written response to questions about Fort Snelling, an NCUA spokesman said it became aware of Fort Snelling's "lending issues" in 2007 but "remedial actions did not correct the problems." The NCUA said: "The declining financial condition of the credit union, combined with a downturn in the local economy, necessitated the merger" with Hiway.
However, the risks of commercial real estate lending were hardly unfamiliar to either lenders or regulators. Less than two decades earlier, more than 700 savings and loans failed, including Minneapolis-based Midwest Federal Savings, largely because of unsound real estate loans.
When Congress created the Office of Thrift Supervision (OTS) in response, it capped the amount of commercial real estate loans that savings and loans could make. In 2009, commercial real estate loans represented just 13 percent of troubled assets at those institutions, down from nearly 70 percent in 1990, according to the OTS.
Banks have no such limits, and while federal law restricts how much credit unions can lend to businesses, there are no limits on home loans. Today, the average credit union in Minnesota has 57 percent of its loans in real estate, mostly home loans and lines of credit. Regulators used to consider 25 percent worth more scrutiny.
In 2003, as NCUA chairman, Dennis Dollar advised credit unions to be careful about plunging too deeply into real estate lending. But the federal regulator, he wrote, "does not prescribe a fixed, maximum percentage of mortgage loans" in a lending portfolio.
In 2006, federal bank regulators proposed guidelines -- not limits or new rules -- that could be used to determine whether a bank had a high concentration of commercial real estate loans in its portfolio.
Bankers fought it. The American Bankers Association fired off a 10-page analysis of the proposal, opposing it as a costly one-size-fits-all approach. Federal regulators received more than 4,400 comment letters, many from small bankers arguing that regulating commercial real estate lending could choke off a vital money-maker.
The guidance on commercial real estate exposure became official in December 2006. At the time, 115 Minnesota banks were over the most basic threshold. This spring, 131 were, with nine of them at levels more than double the federal threshold.
Murphy, the Department of Commerce official, said his division largely dismissed the guidance as "fairly crude" and just a "starting place" for further analysis of state banks. You can't look at the real estate concentrations by themselves, he said, because a bank could be very well-capitalized and in a good position to manage it.
But some weren't.
'Our bank is closed'
Most of the 3,100 residents of Pine City, Minn., had gone home for the day when the FDIC's so-called resolutions team descended on Horizon Bank on a Friday night in June.
They came in small numbers at first. By nightfall, however, the bank was teeming with more than 50 accountants in suits, poring over documents while eating chicken and brownies. They stayed until 11 p.m. but were back the following morning to greet the bank's customers.
"All we know is our bank is closed," said a frustrated Judy Malenke, 68, of Pine City, as she emerged from the bank. "They're not telling us anything else."
The regulatory findings that led to that late-night closure of Horizon remain a secret. Federal and state bank regulators do not share the examination reports that lead to disciplinary actions or bank failures; nor do they disclose the conversations they have with individual banks and credit unions. Their actions remain largely hidden from public view, making it difficult, if not impossible, to gauge their effectiveness, say regulatory experts.
Regulators say the lack of transparency is by design. They want to prevent a panic that might cause a run on a bank. Confidentiality also ensures that banks executives cooperate when examiners show up.
"We want them to be honest with us about what's going on in the banks," said Fred Fisch, supervisory counsel for the FDIC.
The Minnesota Commerce Department does release information on when a bank is examined and the hours spent. The information, obtained by the Star Tribune through a public records request, is included on thousands of pink examination receipts kept at Commerce's offices.
In Horizon's case, the reports show only that state regulators conducted three on-site exams of the bank since early 2008, spending a total of 513.75 hours at the bank. That includes a 52-hour exam in March, less than four months before the bank was closed. However, there is no mention in the reports of any unusual finding that would explain why the regulators appeared, unannounced, on that Friday night in June.
The exam receipts are about the only way to monitor how much time state regulators spend actually monitoring the safety and soundness of Minnesota's financial institutions. And it is clear that the department entered the boom with fewer resources than it had before, and that it continued paring back during a period of rapid consolidation and growth in the financial sector.
In 2008, for instance, the Commerce Department spent 15 percent fewer hours examining banks and credit unions that it had just five years earlier, according to data collected by the Star Tribune from exam receipts. Total exam hours fell from 43,088 in 2003 to 36,507 in 2008, while the number of exams fell from 211 to 158 over the same period. The number of examiners, meanwhile, declined from 33 to 30, according to the Commerce Department.
While Minnesota has 80 fewer state-charted banks and credit unions than in 2000, total assets at the remaining institutions swelled 63 percent during the same period. In addition, the ranks of state-charted institutions include a number of new banks formed in the past decade, some of which are now struggling with heavy loads of bad commercial real estate loans.
Even with the consolidation, Minnesota has the lowest ratio of examiners to banks in the nation. The state comes in dead last when comparing numbers of bank examiners to banks, savings and loans and trusts, based on 2007 numbers, the most recent available from the Conference of State Bank Supervisors.
Minnesota has four examiners assigned to its 96 state-chartered credit unions; Mississippi, by contrast, had the same number examining 29 credit unions, as of the end of 2007, according to the National Association of State Credit Union Supervisors, which tracks the numbers for 33 states.
In addition, Minnesota is one of just four states in the country that has a 24-month examination cycle for credit unions, the result of a legislative change in 2003 urged by the Commerce Department. Most states examine credit unions every 12 to 18 months.
By contrast, federal regulators keep credit unions on a much shorter leash. In 2008 the NCUA shortened its exam cycle to just a year after its chairman, Michael Fryzel, declared that the agency's 18-24 month cycle was "totally unacceptable in this economic climate." The NCUA's board also approved the hiring of 50 new examiners.
'We're doing more with less'
Commerce spokesman Bill Walsh said the decline in length and number of exams is largely because the state has shifted more banks over to an exam cycle that alternates with federal regulators.
"We're also getting more efficient," he said. "We're doing more with less."
He noted that state residents have not lost any deposits. "There's no evidence that consumers have suffered because of our regulatory regime," Walsh said.
Joe Witt, president of the Minnesota Bankers Association, said he wasn't aware that the state division has such a low number of examiners, but said that even with more staff they wouldn't have been able to prevent the current problems at many banks.
"A good loan today can be a bad loan tomorrow," Witt said. "You would need an examiner there every day to catch every situation."
In Minnesota, as in most states, fees charged to banks, credit unions and other financial services companies fund the government agencies charged with watching over them.
However, the department's annual budget must still be approved by the Legislature, which means the financial institutions division must jockey with other divisions for resources, said Allyn Long, a former deputy commerce commissioner. "They need to add more people, in my opinion," Long said. "But to do that, they have to justify their existence, and that's never easy with the trade associations and their lobbyists saying they're already regulated enough."
John Gillen, 66, was forced into early retirement when the Commerce Department eliminated his chief examiner job in May 2003 for "budgetary concerns," he was told. "Certainly I wasn't a drain on the taxpayer since my position was funded by the industry. We were always pinching pennies."
Commerce cut Gillen's position because the duties overlapped too much with the assistant commissioner, said Walsh. The division refilled the chief examiner position in October 2008, he said, because of the growing watch list of troubled banks.
At the Legislature, the division's resources haven't been an issue.
"It simply doesn't come up," said Rep. Jim Davnie, DFL-Minneapolis, a member of the House Commerce and Labor Committee. "There is some frustration within the Legislature over what is perceived to be weak regulatory oversight by the Department of Commerce over the entities it regulates. ... But we all wring our hands and no one wants to say anything -- for fear of creating a sense of alarm."