Alliance Bank had a rocky beginning in the early 1980s. Earlier this year, the Culver City business bank met a similarly rocky end.

For the past decade, as a development craze enveloped Southern California, the institution quietly amassed outsized portfolios of construction and commercial real estate loans. During the boom times, the bank’s rapid growth, fueled by volatile funding sources, raised few concerns either within the bank or from regulators.

By virtually all accounts, Alliance represented a classic success story of a bank that took advantage of the market to expand its brand – that is, until the real estate market fell apart. Within just months, much of the bank’s loan portfolio went bad.

Now, an audit released this month by the Federal Deposit Insurance Corp.’s Office of the Inspector General sheds light on the causes of the bank’s failure. The audit also turns a critical eye on the FDIC itself, noting that regulators missed key signs that the bank’s portfolio of so-called ADC loans – for land acquisition, real estate development and construction – was in trouble.

“The Southern California real estate market had severely deteriorated,” the report states. “In retrospect, the May 2007 FDIC examination could have resulted in additional supervisory action to address the significant risks posed by Alliance’s aggressive growth concentrated in ADC lending.”

On Feb. 6, Alliance was seized by the FDIC and sold to California Bank & Trust, a regional bank looking to expand its presence in Los Angeles County. The failure cost the FDIC more than $200 million.

In a jarring sign of just how bad the situation had become for Alliance, California Bank & Trust bought nearly all of Alliance’s assets – $1.12 billion in total – for just $9.9 million. (See main story page 21.)

In response to the audit, Sandra Thompson, director of the FDIC’s division of supervision and consumer protection, sent a memo to the inspector general’s office acknowledging that the FDIC could have taken earlier action, but she noted that the bank’s problems resulted largely from failures by management. The FDIC had no further comment.

Growing pains

In its first six years, Alliance was a mess.

Senior executives came and left with regularity. Bad loans piled up. Regulators threatened to shut the institution down.

But in 1986, Curtis Reis brought a measure of stability. The longtime banker took over as president and immediately put down $500,000 to get the institution back on its feet.

It struggled through the savings and loan crisis, shrinking its staff from 50 to 15. But Reis brought in more customers and developed long-term relationships. Before too long, the bank was actually profitable, though it stayed small through 1996, averaging just $44 million in assets. Then it all changed.

“Beginning in 1997, Alliance management embarked on a strategy of aggressive growth,” the inspector general said in its audit.

The bank made the fateful decision that year to open a construction loan division. By 2000, regulators took notice of the bank’s growth, issuing a memorandum of understanding that directed management to reduce concentrations of the risky loans.

The order, which lasted for one year, was considered a success, with regulators noting at the time that the bank had made “significant progress” in reducing the concentrations. However, almost immediately after the order was lifted, Alliance resumed its growth initiative.

From 2001 to 2002, the bank’s assets increased by 28 percent, according to the audit. The following year, assets rose by an additional 46 percent – and continued to grow similarly throughout the boom. By 2007, assets topped $1 billion.

“Rapid growth really increases the risk of failure,” said Bert Ely, a bank consultant in Alexandria, Va. “You stress your organization; you stress your systems. With rapid growth, the more likely you are to make mistakes.”

Underlying Alliance’s growth was a notion that real estate prices would not see any sharp drop-off. In a 2005 interview with RMA Journal, a financial services trade publication, Reis said a real estate downturn was unlikely.

“Some leveling off of prices could be desirable, but I don’t think you’ll see the market here go into free fall,” said Reis, who was not made available to comment for this article.

Few concerns

For the most part, regulators looked the other way as the bank’s assets ballooned, noting just minor concerns during the annual examinations, according to the audit.

In 2006, for instance, regulators found certain loans that did not have current financial statements or tax returns. But none of the weaknesses drew any formal rebuke, and the bank’s annual examination in 2007 by the FDIC found that the bank had more favorable loan concentrations.

Alliance sold a portion of its commercial real estate loan portfolio and opened a new branch to increase core deposits.

In January 2008, Reis was named Banker of the Year by the California Bankers Association.

Suddenly, however, with a swiftness that surprised even longtime industry players, the real estate market in Southern California collapsed.

Over the following year, the bank’s substandard loans, known as “classified loans,” surged nearly 700 percent to $176 million, the audit found. The bank had tens of millions of dollars in speculative residential construction loans largely in the Inland Empire, which were going bad at a rapid pace.

Liquidity, meanwhile, became strained, which presented an even more immediate problem for the bank.

Since 2002, the bank had increased its reliance on wholesale funding sources, including brokered deposits and Federal Home Loan Bank borrowings, to fund its growth, according to the audit. Brokered deposits – short-term, high-interest deposits also known as “hot money” – tend to flee when a bank stops paying high rates.

“The non-core funding dependence resulted in a liquidity crisis during 2008 when the bank’s loan portfolio deteriorated, which ultimately led to Alliance’s failure,” the audit said.

In October, with loan losses mounting and capital dropping, regulators issued a cease-and-desist order requiring the bank to raise $30 million within 60 days. But it was too late. Regulators began shopping Alliance to potential acquirers, and found a taker in California Bank & Trust.