An appraisal of lending and collection policies, the bank's adherence thereto, and the evaluation of individual loans are among the most important aspects of the examination process. To a great extent, it is the quality of a bank's loan portfolio that determines the risk to depositors and to the FDIC's insurance fund. Conclusions regarding the condition of the bank and the quality of its management are weighted heavily by the examiner's findings with regard to lending practices. Emphasis on review and appraisal of the loan portfolio and its administration by bank management during examinations recognizes, first, that loans comprise a major portion of the asset structures of most banks, and, second, that it is the asset category which ordinarily presents the greatest credit risk and, therefore, potential loss exposure to banks. Moreover, pressure for increased profitability, liquidity considerations, and a vastly more complex society have produced great innovations in credit instruments and approaches to lending. Loans have consequently become much more complex. Examiners therefore find it necessary to devote a large portion of their time and attention to examination of bank loan portfolios.
Loan Administration
Lending Policies
The examiner's evaluation of the loan portfolio involves much more than merely appraising the individual loans therein. Prudent management and administration of the overall loan account, including establishment of sound lending and collection policies, are of vital importance if the bank is to be continuously operated in an acceptable manner.
Lending policies should be clearly defined and set forth in such a manner as to provide effective supervision by the directors and senior officers. Inasmuch as the board of directors of every bank has the legal responsibility to formulate lending policies and to supervise their implementation, examiners should encourage establishment and maintenance of written, up-to-date lending policies which have been approved by the board of directors. A bank's lending policy should not be a static document, but must be reviewed periodically and revised in light of changing circumstances surrounding the borrowing needs of the bank's customers as well as changes that may occur within the bank itself. To a large extent, the economy of the community served by the bank dictates the composition of the loan account. The widely divergent circumstances of regional economies and the considerable variance in characteristics of individual loans preclude establishment of standard or universal lending policies. There are, however, certain broad areas of consideration and concern that should be addressed in the lending policies of all banks regardless of size or location. These include the following, as minimums:
The above are designed to serve only as guidelines for areas needing consideration in overall policy evaluation. Examiners should also encourage management to develop specific guidelines for each lending department or function. As with overall lending policies, it is not the FDIC's intent to suggest universal or standard loan policies for specific types of credit. The establishment of these policies is the responsibility of each bank's board of directors and management. Therefore, the following discussion of basic principles applicable to various types of credit will not include or allude to acceptable ratios, levels, comparisons or terms. These matters should, however, be addressed in each bank's lending policy, and it will be the examiner's responsibility to determine whether the policies are realistic and being followed.
Much of the rest of this section of the Manual discusses areas that should be considered in the bank's lending policies. Guidelines for their consideration are discussed under the appropriate areas.
The term "loan review system" refers to the responsibilities assigned to various areas such as credit underwriting, loan administration, problem loan workout, or other areas. Responsibilities may include assigning initial credit grades, ensuring grade changes are made when needed, or compiling information necessary to assess the adequacy of the ALLL.
The complexity and scope of a loan review system will vary based upon an institution's size, type of operations, and management practices. Systems may include components that are independent of the lending function, or may place some reliance on loan officers. Although smaller institutions are not expected to maintain separate loan review departments, it is essential that all institutions maintain an effective loan review system.
Regardless of its complexity, an effective loan review system is generally designed to address the following objectives:
Accurate and timely credit grading is a primary component of an effective loan review system. Credit grading involves an assessment of credit quality, the identification of problem loans, and the assignment of risk ratings. An effective system provides information for use in establishing valuation allowances for specific credits and for the determination of an overall ALLL level.
Credit grading systems often place primary reliance on loan officers for identifying emerging credit problems. However, given the importance and subjective nature of credit grading, a loan officer's judgement regarding the assignment of a particular credit grade should generally be subject to review. Reviews may be performed by peers, superiors, or loan committee(s), or by other internal or external credit review specialists. Credit grading reviews performed by individuals independent of the lending function are preferred because they often provide a more conservative assessment of credit quality. A loan review system should, at a minimum, include the following:
Management should maintain a written loan review policy that is reviewed and approved at least annually by the board of directors. Policy guidelines should include a written description of the overall credit grading process, and establish responsibilities for the various loan review functions. The policy should generally address the following items:
Personnel involved in the loan review function should be qualified based on
level of education, experience, and extent of formal training. They should be
knowledgeable of both sound lending practices and their own institution's
specific lending guidelines. In addition, they should be knowledgeable of
pertinent laws and regulations that affect lending activities.
Loan officers should be responsible for ongoing credit analysis and the
prompt identification of emerging problems. Because of their frequent contact
with borrowers, loan officers can usually identify potential problems before
they become apparent to others. However, institutions should be careful to avoid
over reliance upon loan officers. Management should ensure that, when feasible,
all significant loans are reviewed by individuals that are not part of, or
influenced by anyone associated with, the loan approval process.
Larger institutions typically establish separate loan review departments
staffed by independent credit analysts. Cost and volume considerations may not
justify such a system in smaller institutions. Often, members of senior
management that are independent of the credit administration process, or a
committee of outside directors, fills this role. Regardless of the method used,
loan review personnel should report their findings directly to the board of
directors or a committee thereof.
The loan review function should provide feedback on the effectiveness of the
lending process in identifying emerging problems. Reviews of significant credits
should generally be performed annually, upon renewal, or more frequently when
factors indicate a potential for deteriorating credit quality. A system of
periodic reviews is particularly important to the ALLL determination process.
Reviews should cover all loans that are considered significant. In addition
to loans over a predetermined size, management will normally review smaller
loans that present elevated risk characteristics such as credits that are
delinquent, on nonaccrual status, restructured, previously classified, or
designated as special mention. Additionally, management may wish to periodically
review insider loans, recently renewed credits, or loans affected by common
repayment factors. The percentage of the portfolio selected for review should
provide reasonable assurance that all major credit risks have been identified.
Loan reviews should analyze a number of important credit factors, including:
Loan review findings should be reviewed with appropriate loan officers,
department managers, and members of senior management. Any existing or planned
corrective action (including estimated timeframes) should be elicited for all
noted deficiencies. All deficiencies that remain unresolved should be reported
to senior management and the board of directors.
A list of the loans reviewed, including the date of the reviews, and
documentation supporting assigned ratings, should be prepared. A report that
summarizes the results of the review should be submitted to the board at least
quarterly. Findings should address adherence to internal policies and
procedures, and applicable laws and regulations, so that deficiencies can be
remedied in a timely manner.
Federally insured depository institutions must maintain an ALLL at a level
that is adequate to absorb the estimated credit losses associated with the loan
and lease portfolio (including all binding commitments to lend). To the extent
not provided for in a separate liability account, the ALLL should also be
sufficient to absorb estimated credit losses associated with off-balance sheet
credit instruments such as standby letters of credit.
The term "estimated credit losses" means an estimate of the current amount of
the loan and lease portfolio (net of unearned income) that is not likely to be
collected; that is, net chargeoffs that are likely to be realized for a loan, or
pool of loans. The estimated credit losses should meet the criteria for accrual
of a loss contingency ( i.e., a provision to the ALLL) set forth in generally
accepted accounting principals (GAAP). When available information confirms
specific loans and leases, or portions thereof, to be uncollectible, these
amounts should be promptly charged-off against the ALLL.
Estimated credit losses should reflect consideration of all significant
factors that affect repayment as of the evaluation date. Estimated losses on
loan pools should reflect historical net chargeoff levels for similar loans,
adjusted for changes in current conditions or other relevant factors.
Calculation of historical chargeoff rates can range from a simple average of net
chargeoffs over a relevant period, to more complex techniques, such as migration
analysis.
Portions of the ALLL can be attributed to, or based upon the risks associated
with, individual loans or groups of loans. However, the ALLL is available to
absorb credit losses that arise from the entire portfolio. It is not segregated
for any particular loan, or group of loans.
It is the responsibility of the board of directors and management to maintain
the ALLL at an adequate level. The allowance adequacy should be evaluated, and
appropriate provisions made, at least quarterly. In carrying out their
responsibilities, the board and management are expected to:
For purposes of Reports of Condition and Income and Thrift Financial Reports
an adequate ALLL should, after deduction of all assets classified loss, be no
less than the sum of the following items:
Furthermore, management's analysis of an adequate reserve level should be
conservative to reflect a margin for the imprecision inherent in most estimates
of expected credit losses. This additional margin might be incorporated through
amounts attributed to individual loans or groups of loans, or in an unallocated
portion of the ALLL.
When determining an appropriate allowance, primary reliance should normally
be placed on analysis of the various components of a portfolio, including all
significant credits reviewed on an individual basis (Refer to FASB No. 114 for
additional guidance in establishing reserves for impaired credits that are
reviewed individually). When analyzing the adequacy of an allowance, portfolios
should be segmented into as many components as practical. Each component should
normally have similar characteristics, such as risk classification, past due
status, type of loan, industry, or collateral. A depository institution may, for
example, analyze the following components of its portfolio and provide for them
in the ALLL:
In addition to estimated credit losses, the losses that arise from the
transfer risk associated with an institution's cross-border lending activities
require special consideration. Over and above any minimum amount that is
required by the Interagency Country Exposure Review Committee to be provided in
the Allocated Transfer Reserve (or charged to the ALLL), an institution must
determine if their ALLL is adequate to absorb estimated losses from transfer
risk associated with its cross-border lending exposure.
Estimated credit losses should reflect consideration of all significant
factors that affect collectibility of the portfolio as of the evaluation date.
While historical loss experience provides a reasonable starting point,
historical losses, or even recent trends in losses, are not by themselves, a
sufficient basis to determine an adequate level. Management should also consider
any factors that are likely to cause estimated losses to differ from historical
loss experience, including but not limited to:
Institutions are also encouraged to use ratio analysis as a supplemental
check for evaluating the overall reasonableness of an allowance. Ratio analysis
can be useful in identifying trends in the relationship of the ALLL to
classified and nonclassified credits, to past due and nonaccrual loans, to total
loans and leases and binding commitments, and to historical chargeoff levels.
However, while such comparisons can be helpful as a supplemental check of the
reasonableness of management's assumptions and analysis, they are not, by
themselves, a sufficient basis for determining an adequate reserve level. Such
comparisons do not eliminate the need for a comprehensive analysis of the loan
and lease portfolio and the factors affecting its collectibility.
Examiners are responsible for assessing the quality of the loan and lease
portfolio, the loan review system, and the adequacy of the ALLL. Examiners
should consider all significant factors that affect the collectibility of the
portfolio. Examination procedures for reviewing the adequacy of the ALLL are
included in the Examination Modules Handbook in the section "Loan Portfolio
Management and Review."
In assessing the overall adequacy of an ALLL, it is important to recognize
that the related process, methodology, and underlying assumptions require a
substantial degree of judgement. Credit loss estimates will not be precise due
to the wide range of factors that must be considered. Furthermore, the ability
to estimate credit losses on specific loans and categories of loans improves
over time. Therefore, examiners will generally accept management's estimates of
credit losses in their assessment of the overall adequacy of the ALLL when
management has:
After the completion of all aspects of the ALLL review described in this
section, if the examiner does not concur that the reported ALLL level is
adequate, or the ALLL evaluation process is deficient, recommendations for
correcting these problems, including any examiner concerns regarding an
appropriate level for the ALLL, should be noted in the report of examination.
An ALLL established in accordance with the guidelines provided above should
fall within a range of acceptable estimates. When an ALLL is deemed inadequate,
management will be required to increase the provision for loan and lease loss
expense sufficiently to restore the ALLL reported in its Call Report or TFR to
an adequate level.
The current authoritative source of accounting guidance addressing the
overall adequacy of an ALLL under GAAP is the Financial Accounting Standards
Board's Statement No. 5, Accounting for Contingencies (FASB 5). FASB 5
states that an allowance for credit losses should be established when
information prior to the issuance of the financial statements indicates that it
is probable that a loss has occurred and the amount of that loss can be
reasonably estimated. Under GAAP, no differences should exist in the criteria
banks and thrifts use to establish reserves for inherent loan losses.
Examiners are encouraged, with the permission of the depository institution,
to communicate with an institution's external auditors and request an
explanation of their rationale and findings, when differences in judgement
concerning the adequacy of the institution's ALLL exist. In case of controversy,
the auditors may be reminded of the consensus reached by the Financial
Accounting Standards Board's Emerging Issues Task Force (EITF) on Issue No.
85-44, "Differences Between Loan Loss Allowances for GAAP and RAP." This issue
deals with the situation where regulators "have mandated that institutions
establish loan loss allowances under regulatory accounting principles (RAP) that
may be in excess of amounts recorded by the institution in preparing its
financial statement under" GAAP. The EITF was asked whether and under what
circumstances this can occur. The consensus indicated that "auditors should be
particularly skeptical in the case of GAAP/RAP differences and must justify them
based on the particular facts and circumstances."
Additional guidance on the establishment of loan review systems and an
adequate ALLL is provided in the Interagency Statement of Policy on the ALLL
dated December 21, 1993. Accounting guidance relating to the establishment of
reserves for certain impaired credits (individually analyzed credits) is found
in FASB Statement No. 114.
Loans for commercial or industrial purposes to business enterprises, whether
proprietorships, partnerships or corporations, are commonly described by the
term "commercial loans". In asset distribution, commercial or business loans
frequently comprise one of the most important assets of a bank. They may be
secured or unsecured and for short or long-term maturities. Such loans include
working capital advances, term loans and loans to individuals for business
purposes.
Short-term working capital and seasonal loans provide temporary capital in
excess of normal needs. They are used to finance seasonal requirements and are
repaid at the end of the cycle by converting inventory and accounts receivable
into cash. Such loans may be unsecured, however, many working capital loans are
advanced with accounts receivable and/or inventory as collateral. Firms engaged
in manufacturing, distribution, retailing and service-oriented businesses use
short-term working capital loans.
Term business loans have assumed increasing importance. Such loans normally
are granted for the purpose of acquiring capital assets, such as plant and
equipment. Term loans may involve a greater risk than do short-term advances,
because of the length of time the credit is outstanding. Because of the
potential for greater risk, term loans are usually secured and generally require
regular amortization. Loan agreements on such credits may contain restrictive
covenants during the life of the loan. In some instances, term loans may be used
as a means of liquidating, over a period of time, the accumulated and unpaid
balance of credits originally advanced for seasonal needs. While such loans may
reflect a borrower's past operational problems, they may well prove to be the
most viable means of salvaging a problem situation and effecting orderly debt
collection.
A bank's commercial lending policies should address at least acquisition of
credit information such as property, operating and cash flow statements, factors
that might determine the need for collateral acquisition, acceptable collateral
margins, perfecting liens on collateral, lending terms, and charge-offs.
Accounts receivable financing is a specialized area of commercial bank
lending in which borrowers assign their interests in accounts receivable to the
lender as collateral. Typical characteristics of accounts receivable borrowers
are those businesses that are growing rapidly and need year-round financing in
amounts too large to justify unsecured credit, those that are nonseasonal and
need year-round financing because working capital and profits are insufficient
to permit periodic cleanups, those whose working capital is inadequate for the
volume of sales and type of operation, and those whose previous unsecured
borrowings are no longer warranted because of various credit factors.
Several advantages of accounts receivable financing from the borrower's
viewpoint are: it is an efficient way to finance an expanding operation because
borrowing capacity expands as sales increase; it permits the borrower to take
advantage of purchase discounts because the company receives immediate cash on
its sales and is able to pay trade creditors on a satisfactory basis; it insures
a revolving, expanding line of credit; and actual interest paid may be no more
than that for a fixed amount unsecured loan.
Advantages from the bank's viewpoint are: it generates a relatively high
yield loan, new business, and a depository relationship; permits continuing
banking relationships with long-standing customers whose financial conditions no
longer warrant unsecured credit; and minimizes potential loss when the loan is
geared to a percentage of the accounts receivable collateral.
Although accounts receivable loans are collateralized, it is important to
analyze the borrower's financial statements. Even if the collateral is of good
quality and in excess of the loan, the borrower must demonstrate financial
progress. Full repayment through collateral liquidation is normally a solution
of last resort.
Banks use two basic methods to make accounts receivable advances. First,
blanket assignment, wherein the borrower periodically informs the bank of the
amount of receivables outstanding on its books. Based on information, the bank
advances the agreed percentage of the outstanding receivables. The receivables
are usually pledged on a non-notification basis and payments on receivables are
made directly to the borrower who then remits them to the bank. The bank applies
all or a portion of such funds to the borrower's loan. Second, ledgering the
accounts, wherein the lender receives duplicate copies of the invoices together
with the shipping documents and/or delivery receipts. Upon receipt of
satisfactory information, the bank advances the agreed percentage of the
outstanding receivables. The receivables are usually pledged on a notification
basis. Under this method, the bank maintains complete control of the funds paid
on all accounts pledged by requiring the borrower's customer to remit directly
to the bank.
In the area of accounts receivable financing, a bank's lending policy should
address at least the acquisition of credit information such as property,
operating and cash flow statements. It should also address maintenance of an
accounts receivable loan agreement that establishes a percentage advance against
acceptable receivables, a maximum dollar amount due from any one account debtor,
financial strength of debtor accounts, insurance that "acceptable receivables"
are defined in light of the turnover of receivables pledged, aging of accounts
receivable, and concentrations of debtor accounts.
The three Federal banking agencies have jointly adopted a common definition
of HLTs. For supervisory purposes, a bank or bank holding company is considered
to be involved in an HLT when credit is extended or investment is made in a
business where the financing transaction involves the buyout, acquisition, or
recapitalization of an existing business. In addition to the purpose test, one
of the following criteria must be met for the transaction to be considered an
HLT.
In those cases where a credit meets the purpose test but is not covered by
any of the criteria above, the bank supervisory agencies may nevertheless
designate the credit as an HLT. It is anticipated that this would be done
infrequently and only in material cases.
Total exposure to individual HLT borrowers includes all loans, extensions of
credit, and debt and equity securities relating to acquisitions or restructuring
transactions as well as any ordinary business loans to or investments in, the
same obligor. Total exposure also includes standby letters of credit, legally
binding contractual commitments, and other financial guarantees. The agencies
will include all obligations of, and claims on, HLT borrowers, regardless of
perceived credit quality or secured status.
The leverage ratio for these purposes is total liabilities divided by total
assets. Total liabilities include all forms of debt and claims, including all
subordinated debt and non-perpetual preferred stock. Total assets include
intangible assets.
Examiners should determine whether the board has approved a separate policy
for approving and reporting on HLTs. Such a policy should supplement policies
used in the normal credit process. It should ensure that all loans identified as
HLTs are reviewed and approved through a separate and distinct process. To
determine adherence, examiners should review the internal listing of HLTs and
ensure that it captures all financing with similar levels of risk (e.g., LBOs,
recapitalizations, cashouts, etc.). If some credits related to HLTs are not
included, examiners should determine the reasons for, and the significance of,
omissions.
The lending policy should include:
Examiners should review all MIS and reporting system date on HLTs. The system
should provide the following information and analysis.
Examiners should review all policies and procedures that relate to
HLT-related asset sales, distribution and syndication efforts. The policies
should include:
Concentration of Credit - Aggregating all HLT transactions together as a
concentration in an institution has analytical merit because high leverage
entails high risk. The evaluation of a bank with an HLT concentration should
carefully consider the potential effect of increased rates on the payment
ability of the borrowers and thus the effect on the bank. However, mitigating
factors should also be considered. HLTs can be diversified among industries that
respond differently to economic cycles. Risk also can be diversified by holding
small pieces of numerous HLT deals rather than concentrating exposure in a few
transactions.
In addition to reviewing the total volume of a banking organization's HLTs,
examiners should assess the extent to which the organization's income includes
fees and commissions relating to HLTs. Examiners should also take into account
the extent to which income includes gains on the sale of equity holdings. When
listing HLT concentrations in reports of examination, the degree of criticism
accorded, if any, will depend on the individual bank's circumstances, including:
the diversification within the HLT portfolio; the quality of the individual
credits; the general level of other risks in the bank; management expertise;
policies and internal controls; management's demonstrated ability to conduct an
independent credit analysis of each transaction; and the capital and earnings
capacity of the bank. Banks that do not have the expertise to conduct in-house
independent credit analyses of HLTs should not be engaging in, or buying
participations in, such transactions.
Because collateral functions as a secondary repayment source in the event
repayment plans go awry, industries without meaningful tangible assets, such as
the service sector, all other things being equal, contain an incremental degree
of risk. Such industries need not be excluded from HLT financing, but the
absence of comfort provided by tangible assets that can be liquidated should be
factored into the credit evaluation process.
Particular attention should be paid to the adequacy of a borrower's cash
flow. Banking organizations should make an independent and realistic assessment
of the borrower's cash flow projections under varying economic and interest rate
assumptions, including a worst case scenario, and be able to demonstrate that
they have taken into account the potential effects of an economic downturn on a
borrower's cash flow and collateral values before becoming involved in an HLT. A
loan whose repayment is not predicated on an identifiable and historically
stable source of cash flow has speculative qualities. Reliance for loan
repayment on the sale of assets or subsidiaries whose values are not clearly
supported by a historically demonstrated ability to produce adequate cash flow,
a firm sales contract or "take-out" commitment, or a realistic cash-generating
capacity based on current economic conditions, is an inappropriate banking
practice that could expose a bank to undue risks. Such loans should receive
careful supervisory scrutiny and, under normal circumstances, should be subject
to examiner comment or criticism. Ordinarily, unless conservatively projected
cash inflows provide a reasonable margin above the total debt service
requirements and other fixed expenditures of the borrower, classification of the
credit is appropriate.
When the proceeds of assets sales play an important role in reducing the
debt, the methods used to determine asset valuations and projected sale proceeds
should be carefully scrutinized. In addition, asset collateral coverage should
be reassessed periodically throughout the life of the debt, and actual sales
proceeds should be compared to projections made at origination of the HLT in
order to monitor the reasonableness of the lender's assumptions concerning
valuations. Repayment programs should specify the sources and timing of
repayment, and any significant deviations from the programs should be evaluated.
The amount of senior debt in relation to total financing should be carefully
reviewed. In general, a bank's risk can be reduced if its position is senior to
all other levels of debt and secured by a first lien on assets or all the stock
of the borrower's operating entities. Ideally, the debt structure should permit
the borrower to suspend payments on junior debt should circumstances so warrant.
Special attention should be given to the risks associated with short-term bridge
financing in connection with highly-leveraged restructurings. Such risks may be
greater than normal because these loans are typically subordinated to other
debt, may not be collateralized, and depend on the successful marketing of
longer term securities or the sale of assets for repayments.
These guidelines apply to oil and/or gas reserve-based loans that are
considered collateral dependent and are devoid of repayment capacity from other
tangible sources.
The initial step to assessing the credit worthiness of reserve-based loans is
an analysis of the engineering function. Cash flow generated from the future
sale of encumbered oil and/or gas reserves is the primary, and in most cases the
only intended, source of repayment. Therefore, the integrity of engineering data
that depicts that future cash stream is critical to the initial lending decision
and equally important to an examiner in the assessment of credit quality. For
evaluation purposes, an acceptable engineering report must be an independent,
detailed analysis of the reserve prepared by a competent engineering group. The
report must address three critical concerns: (i) pricing; (ii) discount factors;
and (iii) timing. In those cases where the engineering reports do not meet one
or more of these criteria, the examiner may need to use other methods, e.g.,
recent cash flow histories, to determine the current collateral value.
The extent of examiner analysis is a matter of judgment, but comprehensive
analysis of the credit should definitely take place if: (i) The loan balance
exceeds 65% of the discounted present worth of future net income (PWFNI) of
proved developed producing properties (PDP), or the cash flow analysis indicates
that the loan will not amortize over four to five years; (ii) The credit is not
performing in accordance with terms or repayment of interest and/or principal;
or (iii) The credit is identified by the bank as a "problem" credit.
After performing the analysis, the examiner must determine if classification
is warranted. The following guidelines are to be applied in instances where the
obligor is devoid of primary and secondary repayment capacity or other reliable
means of repayment, with total support of the debt provided solely by the
pledged collateral: (i) 65% of discounted PWFNI should be classified
Substandard. A lesser percentage or less severe criticism may be appropriate in
cases where a reliable alternate means of repayment exists for a portion of the
debt. The 65% percentage should be used when the discounted PWFNI is determined
using historical production data. When less than 75% of the reserve estimate is
determined using historical production data, or the discounted PWFNI is
predicated on engineering estimates of the volume of oil/gas flow (volumetric
and/or analogy-based engineering data), the collateral value assigned to
Substandard should be reduced accordingly. (ii) The balance, but not more than
100% of discounted PWFNI of PDP reserves, should be classified Doubtful. (iii)
Any remaining deficiency balance should be classified Loss.
In addition to PDP, many reserve-based credit collateral values will include
items variously referred to as proved (or proven) developed non-producing
reserves, shut-in reserves, behind-the-pipe reserves and proved undeveloped
properties (PUP) as collateral. Due to the nature of these other reserves, there
are no strict percentage guidelines for the proportion of the credit supported
by this type of collateral that should remain as a bankable asset. However, only
in very unusual situations would the proportion of collateral values for these
other reserves assigned to a classification category approach values for PDP.
The examiner must ascertain the current status of each reserve and develop an
appropriate collateral value. Examples could be reserves that are shut-in due to
economic conditions versus reserves that are shut-in due to the absence of
pipeline or transportation. PUP require careful evaluation before allowing any
bankable collateral value.
Real estate loans (loans principally secured by liens on real property) are
part of the loan portfolios of almost all commercial banks. Real estate loans
include credits advanced for the purchase of real property. However, the term
may also encompass extensions granted for other purposes, but for which primary
collateral protection is real property.
The degree of risk in a real estate loan depends primarily on the loan amount
in relation to collateral value, the interest rate, and most importantly, the
borrower's ability to repay in an orderly fashion. It is extremely important
that a bank's real estate loan policy ensure that loans are granted with the
reasonable probability the debtor will be able and willing to meet the payment
terms. Placing undue reliance upon a property's appraised value in lieu of an
adequate initial assessment of a debtor's repayment ability is a potentially
dangerous mistake.
Historically, many banks have jeopardized their capital structure by granting
ill-considered real estate mortgage loans. Apart from unusual, localized,
adverse economic conditions which could not have been foreseen, resulting in a
temporary or permanent "wash out" of realty values, the principal errors made in
granting real estate loans include inadequate regard to normal or even depressed
realty values during periods when it is in great demand thus inflating the price
structure, mortgage loan amortization, the maximum debt load and paying capacity
of the borrower, and failure to reasonably restrict mortgage loans on properties
for which there is limited demand.
A principal indication of a troublesome real estate loan is an improper
relationship between the amount of the loan, the potential sale price of the
property, and the availability of a market. The potential sale price of a
property may or may not be the same as its appraised value. The current
potential sale price or liquidating value of the property is of primary
importance and the appraised value is of secondary importance. There may be
little or no current demand for the property at its appraised value and it may
have to be disposed of at a sacrifice value.
Examiners must appraise not only individual mortgage loans, but also the
overall mortgage lending and administration policies of the bank to ascertain
the soundness of its mortgage loan operations as well as the liquidity contained
in the account. The bank should establish policies that address the following
factors: the maximum amount that may be loaned on a given property, in a given
category, and on all real estate loans; the need for appraisals (professional
judgments of the present and/or future value of the real property) and for
amortization on certain loans.
Section 18(o) of the FDI Act requires the Federal banking agencies to adopt
uniform regulations prescribing standards for loans secured by liens on real
estate or made for the purpose of financing permanent improvements to real
estate. For FDIC-supervised institutions, Part 365 of the FDIC Rules and
Regulations requires each institution to adopt and maintain written real estate
lending policies that are consistent with sound lending principles, appropriate
for the size of the institution and the nature and scope of its operations.
Within these general parameters, the regulation specifically requires an
institution to establish policies that include:
These policies also should reflect consideration of the "Interagency
Guidelines for Real Estate Lending Policies" and must be reviewed and approved
annually by the institution's board of directors.
The interagency guidelines, which are an appendix to Part 365, are intended
to help institutions satisfy the regulatory requirements by outlining the
general factors to consider when developing real estate lending standards. The
guidelines suggest maximum supervisory loan-to-value (LTV) limits for various
categories of real estate loans and explain how the agencies will monitor their
use.
Institutions are expected to establish their own internal LTV limits
consistent with their needs. These internal limits should not exceed the
following recommended supervisory limits:
Certain real estate loans are exempt from the supervisory LTV limits because
of other factors that significantly reduce risk. These include loans guaranteed
or insured by the federal, state or local government as well as loans to be sold
promptly in the secondary market without recourse. A complete list of excluded
transactions is included in the guidelines.
Because there are a number of credit factors besides LTV limits that
influence credit quality, loans that meet the supervisory LTV limits should not
automatically be considered sound, nor should loans that exceed the supervisory
LTV limits automatically be considered high risk. However, loans that exceed the
supervisory LTV limit should be identified in the institution's records and the
aggregate amount of these loans reported to the institution's board of directors
at least quarterly. The guidelines further state that the aggregate amount of
loans in excess of the supervisory LTV limits should not exceed the
institution's total capital. Moreover, within that aggregate limit, the total
loans for all commercial, agricultural and multi-family residential properties
(excluding 1-to-4 family home loans) should not exceed 30 percent of total
capital.
It is important to distinguish between the regulation and the interagency
guidelines. While the guidelines are included as an appendix to the regulation,
they are not part of the regulation. Therefore, when an apparent violation of
Part 365 is identified, it should be listed in the examination report in the
same manner as other apparent violations. Conversely, when an examiner
determines that an institution is not in conformance with the guidelines and the
deficiency is a safety and soundness concern, an appropriate comment should be
included in the examination report, however, the deficiency would not be a
violation of the regulation.
Examination Procedures for various real estate loan categories are included
in the Examination Modules Handbook.
These loans comprise a major portion of many banks' loan portfolios. When
problems exist in the real estate markets that the bank is servicing, it is
necessary for examiners to devote additional time to the review and evaluation
of loans in these markets.
There are several warning signs that real estate markets or projects are
experiencing problems that may result in real estate values decreasing from
original appraisals or projections. Adverse economic developments and/or an
overbuilt market can cause real estate projects and loans to become troubled.
Signs of troubled real estate markets or projects include but are not limited
to:
A construction loan is used to construct a particular project within a
specified period of time and should be controlled by supervised disbursement of
a predetermined sum of money. It is generally secured by a first mortgage or
deed of trust and backed by a purchase or takeout agreement from a financially
responsible permanent lender. Construction loans are vulnerable to a wide
variety of risks. The major risk arises from the necessity to complete projects
within specified cost and time limits. The risk inherent in construction lending
can be limited by establishing policies that specify that type and extent of
bank involvement. Such policies should define procedures for controlling
disbursements and collateral margins and assuring timely completion of the
projects and timely repayment of the bank's loans.
Before a construction loan agreement is entered into, the bank should
investigate the character, expertise, and financial standing of all related
parties. Documentation files should include background information concerning
reputation, work and credit experience, and financial statements. Such
documentation should indicate that the developer, contractor, and subcontractors
have demonstrated the capacity to successfully complete the type of project to
be undertaken. The appraisal techniques used to value a proposed construction
project are essentially the same as those used for other types of real estate.
The bank should realize that appraised collateral values are not usually met
until funds are advanced and improvements made.
The bank, the builder and the property owner should join in a written
building loan agreement that specifies the performance of each party during the
entire course of construction. Loan funds are generally disbursed based upon
either a standard payment plan or a progress payment plan. The standard payment
plan is normally used for residential and smaller commercial construction loans
and utilizes a preestablished schedule for fixed payments at the end of each
specified stage of construction. The progress payment plan is normally used for
larger, more complex, building projects. The plan is generally based upon
monthly disbursements totaling 90% of the value with 10% held back until the
project is completed.
Although many credits advanced for real estate acquisition, development or
construction are properly considered loans secured by real estate, other such
credits are, in economic substance, "investments in real estate ventures" and
categorization of the asset as "other real estate owned" may be appropriate. A
key feature of these transactions is that the bank as lender plans to share in
the expected residual profit from the ultimate sale or other use of the
development. These profit sharing arrangements may take the form of equity
kickers, unusually high interest rates, a percentage of the gross rents or net
cash flow generated by the project, or some other form of profit participation
over and above a reasonable amount for interest and related loan fees. These
extensions of credit may also include such other characteristics as nonrecourse
debt, 100% financing of the development cost (including origination fees,
interest payments, construction costs, and even profit draws by the developer),
and lack of any substantive financial support from the borrower or other
guarantors. ADC arrangements that are in substance real estate investments of
the bank should be reported accordingly.
On the other hand, if the bank will receive less than a majority of the
expected residual profit, the ADC loan may be analogous to an interest in a
joint real estate venture which would be considered an "investment in
unconsolidated subsidiaries and associated companies."
The following are the basic types of construction lending:
Prudence dictates that permanent financing be assured in advance because the
cost of such financing can have a substantial affect on sales. Proposals to
finance speculative housing should be evaluated in accordance with predetermined
policy standards compatible with the institution's size, technical competence of
its management, and housing needs of its service area. The prospective
borrower's reputation, experience, and financial condition should be reviewed.
The finished project's marketability in favorable and unfavorable market
conditions should be realistically considered. In addition to normal safeguards
such as a recorded first mortgage, acceptable appraisal, construction agreement,
draws based on progress payment plans and inspection reports, a bank dealing
with speculative contractors should institute control procedures tailored to the
individual circumstances. A predetermined limit on the number of unsold units to
be financed at any one time should be included in the loan agreement to avoid
overextending the contractor's capacity.
Loans on larger residential construction projects are usually negotiated with
prearranged permanent financing. Documentation of tract loans frequently
includes a master note allocated for the entire project and a master deed of
trust or mortgage covering all land involved in the project. Payment of the loan
will depend largely upon the sale of the finished homes. As each sale is
completed, the bank makes a partial release of the property covered by its
master collateral document. In addition to making periodic inspections during
the course of construction, periodic progress reports (summary of inventory
lists maintained for each tract project) should be made on the entire project.
The inventory list should show each lot number, type of structure, release
price, sales price, and loan balance.
The exposure in any type of construction lending is that full value of the
collateral does not exist at the time the loan is granted. The bank must ensure
funds are used properly to complete construction or development of the property
serving as collateral. If default occurs, the bank must be in a position to
either complete the project or to salvage its construction advances. The various
mechanic's and materialmen's liens, tax liens, and other judgments that arise in
such cases are distressing to even the most seasoned lender. Every precaution
should be taken by the lender to minimize any outside attack on the collateral.
The construction lender may not be in the preferred position indicated by
documents in the file. Laws of some state favor the subcontractors
(materialmen's liens, etc.), although those of other states protect the
construction lender to the point of first default provided certain legal
requirements have been met. Depending on the type and size of project being
funded, construction lending can be a complex and fairly high-risk venture. For
this reason, a bank's management should ensure that it has enacted policies and
retained sufficiently trained personnel before engaging in this type of lending.
A home equity loan is a loan secured by the equity in a borrower's residence.
It is generally structured in one of two ways. First, it can be structured as a
traditional second mortgage loan, wherein the borrower obtains the funds for the
full amount of the loan immediately and repays the debt with a fixed repayment
schedule. Second, the home equity borrowing can be structured as a line of
credit, with a check, credit card, or other access to the line over its life.
The home equity line of credit has evolved into the dominant form of home
equity lending. This credit instrument generally offers variable interest rates
and flexible repayment terms. Additional characteristics of this product line
include relatively low interest rates as compared to other forms of consumer
credit, absorption by some banks of certain fees (origination, title search,
appraisal, recordation cost, etc.) associated with establishing a real
estate-related loan. The changes imposed by the Tax Reform Act of 1986 relating
to the income tax deductibility of interest paid on consumer debt led to the
increased popularity of home equity lines of credit.
Home equity lending is widely considered to be a low-risk lending activity.
These loans are secured by housing assets, the value of which historically has
performed well. Nevertheless, the possibility exists that local housing values
or household purchasing power may decline, stimulating abandonment of the
property and default on the debt secured by the housing. Certain features of
home equity loans make them particularly susceptible to such risks. First, while
the variable rate feature of the debt reduces the interest rate risk of the
lender, the variable payment size exposes the borrower to greater cash flow
risks than would a fixed-rate loan, everything else being equal. This, in turn,
exposes the lender to greater credit risk. Another risk is introduced by the
very nature of the home equity loan. Such loans are generally secured by a
junior lien. Thus, there is less effective equity protection than in a first
lien instrument. Consequently, a decline in the value of the underlying housing
results in a much greater than proportional decline in the coverage of a home
equity loan. This added leverage makes them correspondingly riskier than first
mortgages.
Banks that make these kind of loans should adopt specific policies and
procedures for dealing with this product line. Management should have expertise
in both mortgage lending as well as open-end credit procedures. Another major
concern is that borrowers will become overextended and the bank will have to
initiate foreclosure proceedings. Therefore, underwriting standards should
emphasize the borrower's ability to service the line from cash flow rather than
the sale of the collateral, especially if the home equity line is written on a
variable rate basis. If the bank has offered a low introductory interest rate,
repayment capacity should be analyzed at the rate that could be in effect at the
conclusion of the initial term.
Other important considerations include acceptable loan-to-value and
debt-to-income ratios, and proper credit and collateral documentation, including
adequate appraisals and written evidence of prior lien status. Another
significant risk concerns the continued lien priority for subsequent advances
under a home equity line of credit. State law governs the status of these
subsequent advances. It is also important that the bank's program include
periodic reviews of the borrower's financial condition and continuing ability to
repay the indebtedness.
The variation in contract characteristics of home equity debt affects the
liquidity of this form of lending. For debt to be easily pooled and sold in the
secondary market, it needs to be fairly consistent in its credit and interest
rate characteristics. The complexity of the collateral structures, coupled with
the uncertain maturity of revolving credit, makes home equity loans considerably
less liquid than straight first lien, fixed maturity mortgage loans.
Agricultural loans are an important component of many community banks' loan
portfolios. Agricultural banks represent a material segment of commercial banks
and constitute an important portion of the group of banks over which the FDIC
has the primary federal supervisory responsibility.
Agricultural loans are used to fund the production of crops, fruits,
vegetables, and livestock, or to fund the purchase or refinance of capital
assets such as farmland, machinery and equipment, breeder livestock, and farm
real estate improvements (for example, facilities for the storage, housing, and
handling of grain or livestock). The production of crops and livestock is
especially vulnerable to two risk factors that are largely outside the control
of individual lenders and borrowers: commodity prices and weather conditions.
While examiners must be alert to, and critical of, operational and managerial
weaknesses in agricultural lending activities, they must also recognize when the
bank is taking reasonable steps to deal with these external risk factors.
Accordingly, loan restructurings or extended terms of repayment, or other
constructive steps to deal with financial difficulties faced by agricultural
borrowers because of adverse weather or commodity conditions, will not be
criticized if done in a prudent manner and with proper risk controls and
management oversight. Examiners should recognize these constructive steps and
fairly portray them in oral and written communications regarding examination
findings. This does not imply, however, that analytical or classification
standards should be compromised. Rather, it means that the bank's response to
these challenges will be considered in supervisory decisions.
Production Loans
(also known as "operating" Loans)
Short-term (one year or less) credits to finance seed, fuel, chemicals, land
and machinery rent, labor, and other costs associated with the production of
crops. Family living expenses are also sometimes funded, at least in part, with
these loans. The primary repayment source is sale of the crops at the end of the
production season when the harvest is completed.
Short-term loans for the purchase of, or production expenses associated with,
cattle, hogs, sheep, poultry or other livestock. When the animals attain market
weight and are sold for slaughter, the proceeds are used to repay the debt.
Intermediate-term credits (generally three to five years) used to fund the
acquisition of breeding stock such as beef cows, sows, sheep, dairy cows, and
poultry. The primary repayment source is the proceeds from the sale of the
offspring of these stock animals, or their milk or egg production.
Intermediate-term loans for the purchase of a wide array of equipment used in
the production and handling of crops and livestock. Cash flow from farm earnings
is the primary repayment source. Loans for grain handling and storage facilities
are also sometimes included in this category, especially if the facilities are
not permanently affixed to real estate.
Farm Real Estate Acquisition Loans
Long-term credits for the purchase of farm real estate, with cash flow from
earnings representing the primary repayment source. Significant, permanent
improvements to the real estate, such as for livestock housing or grain storage,
may also be included within this group.
This term is used to describe two types of agricultural credit. The first is
production or feeder livestock loans that are unable to be paid at their
initial, short-term maturity, and which are rescheduled into an intermediate- or
long-term amortization. This situation arises when weather conditions cause
lower crop yields, commodity prices are lower than anticipated, production costs
are higher than expected, or other factors result in a shortfall in available
funds for debt repayment. The second type of carryover loan refers to
already-existing term debt whose repayment terms or maturities need to be
rescheduled because of inadequate cash flow to meet existing repayment
requirements. This need for restructuring can arise from the same factors that
lead to carryover production or feeder livestock loans. Carryover loans are
generally restructured on an intermediate- or long-term amortization, depending
upon the type of collateral provided, the borrower's debt service capacity from
ongoing operations, the debtor's overall financial condition and trends, or
other variables. The restructuring may also be accompanied by acquisition of
federal guarantees through the farm credit system to lessen risk to the bank.
Agricultural Loan
Underwriting Guidelines
Many underwriting standards applicable to commercial loans also apply to
agricultural credits. The discussion of those shared standards is therefore not
repeated. Some items, however, are especially pertinent to agricultural credit
and therefore warrant emphasis.
Banks should be given some reasonable flexibility as to the level of
sophistication or comprehensiveness of the aforementioned financial information,
and the frequency with which it is obtained, depending upon such factors as the
size of the credit, the type of loans involved, the financial strength and
trends of the borrower, and the economic, climatic or other external conditions
which may affect loan repayment. It may therefore be inappropriate for the
examiner to insist that all agricultural borrowers be supported with the full
complement of balance sheets, income statements, and other data discussed above,
regardless of the nature and amount of the credit or the debtor's financial
strength and payment record. Nonetheless, while recognizing some leeway is
appropriate, most of the bank's agricultural credit lines, and all of its larger
or more significant ones, should be sufficiently supported by the financial
information mentioned.
Examiner review of agricultural related collateral valuations varies
depending on the type of security involved. Real estate collateral should be
reviewed using normal procedures and utilizing Part 323 of the FDIC's Rules and
Regulations as needed. Feeder livestock and grain are highly liquid commodities
that are bought and sold daily in active, well-established markets. Their prices
are widely reported in the daily media, hence, obtaining their market values is
generally easy. The market for breeder livestock may be somewhat less liquid
than feeder livestock or grain, but values are nonetheless reasonably well known
and reported through local or regional media or auction houses. If such
information on breeding livestock is unavailable or is considered unreliable,
slaughter prices may be used as an alternative (these slaughter prices comprise
"liquidation" rather than "going concern" values). Machinery and equipment
values are significantly affected by the extent of use and level of maintenance
received. Determining collateral values can therefore be very difficult as
maintenance and usage levels vary significantly. Nonetheless, values for certain
pre-owned machinery and equipment, especially tractors, combines, and other
harvesting or crop tillage equipment, are published in specialized guides and
are based on prices paid at farm equipment dealerships or auctions. These used
machinery guides may be used as a check on the reasonableness of valuations
presented on financial statements or in management's internal collateral
analyses.
Prudent agricultural loan underwriting also includes systems and procedures
to ensure that the bank has a valid note receivable from the borrower and an
enforceable security interest in the collateral, should judicial collection
measures be necessary. Among other things, such systems and procedures will
confirm that promissory notes, loan agreements, collateral assignments, and lien
perfection documents are signed by the appropriate parties and are filed, as
needed, with the appropriate state, county, and/or municipal authorities. Flaws
in the legal enforceability of loan instruments or collateral documents will
generally be unable to be corrected if they are discovered only when the credit
is distressed and the relationship with the borrower is strained.
In some instances, determining if proper debt structuring is being practiced
requires the examiner to look at the actual payment history of a loan rather
than its formal repayment requirements. That is, an informal payment
understanding may be functioning, even though the promissory note or loan
agreement contain no requirements for interim payments. While the informal
approach is less desirable, because of the possibility that misunderstandings
may occur between debtor and lender, and because of questions over the legal
enforceability of such arrangements, the important point is whether reasonable,
periodic debt reductions are being made.
Two aspects of prudent loan administration deserve emphasis: collateral
control and renewal practices for production loans.
When determining the level of risk in a specific lending relationship, the
relevant factual circumstances must be reviewed in total. This means, among
other things, that when an agricultural loan's primary repayment source is
jeopardized or unavailable, adverse classification is not automatic.
Rather, such factors as the borrower's historical performance and financial
strength, overall financial condition and trends, the value of any collateral,
and other sources of repayment must be considered. In considering whether a
given agricultural loan or line of credit should be adversely classified,
collateral margin is an important, though not necessarily the determinative,
factor. If that margin is so overwhelming as to remove all reasonable prospect
of the bank sustaining some loss, it is generally inappropriate to adversely
classify such a loan. Note, however, that if there is reasonable uncertainty as
to the value of that security, because of an illiquid market or other reasons,
that uncertainty can, when taken in conjunction with other weaknesses, justify
an adverse classification of the credit, or, at minimum, may mean that the
margin in the collateral needs to be greater to offset this uncertainty.
Moreover, when assessing the adequacy of the collateral margin, it must be
remembered that deteriorating financial trends will, if not arrested, typically
result in a shrinking of that margin. Such deterioration can also reduce the
amount of cash available for debt service needs.
There are other general principles to keep in mind when deciding whether
adverse classification is in order:
Examiners should exercise great caution in granting the grain and livestock
exclusion from adverse classification in those instances where the borrower is
very highly leveraged, or where the debtor's basic operational viability is
seriously in question, or if the bank is in an under- secured position. The
issue of control over proceeds becomes extremely critical in such highly
distressed credit situations. If the livestock and grain exclusion from adverse
classification is not given in a particular case, bank management should be
informed of the reasons why.
With the above principles, requirements, and standards in mind, the general
guidelines for determining adverse classification for agricultural loans are as
follows, listed by loan type.
There are no hard and fast rules on whether carryover debt should be
adversely classified, but the decision should generally consider the following:
borrower's overall financial condition and trends, especially financial leverage
(often measured in farm debtors with the debt-to-assets ratio); profitability
levels, trends, and prospects; historical repayment performance; the amount of
carryover debt relative to the size of the customer's operation; realistic
projections of debt service capacity; and the support provided by secondary
collateral. Accordingly, carryover loans to borrowers who are moderately to
highly leveraged, who have a history of weak or no profitability and barely
sufficient cash flow projections, as well as an adequate but slim collateral
margin, will generally be adversely classified, at least until it is
demonstrated through actual repayment performance that there is adequate
capacity to service the rescheduled obligation. The severity of classification
will normally depend upon the collateral position. At the other extreme are
cases where the customer remains fundamentally healthy financially, generates
good profitability and ample cash flow, and who provides a comfortable margin in
the security pledged. Carryover loans to this group of borrowers will not
ordinarily be adversely classified.
A bank's instalment loan portfolio is usually comprised of a large number of
small loans scheduled to be amortized over a specific period. Most instalment
loans are made directly for consumer purchases, but business loans granted for
the purchase of heavy equipment or industrial vehicles may also be included. In
addition, the department may grant indirect loans for the purchase of consumer
goods.
The examiner's emphasis in reviewing the instalment loan department should be
on the overall procedures, policies and credit qualities. The goal should not be
limited to identifying current portfolio problems, but should include potential
future problems that may result from ineffective policies, unfavorable trends,
potentially dangerous concentrations, or nonadherence to established policies.
At a minimum, a bank's direct instalment lending policies should address the
following factors: loan applications and credit checks; terms in relation to
collateral; collateral margins; perfection of liens; extensions, renewals and
rewrites; delinquency notification and follow-up; and charge-offs and
collections. For indirect lending, the policy additionally should address direct
payment to the bank vs. payment to the dealer, acquisition of dealer financial
information, possible upper limits for any one dealer's paper, other standards
governing acceptance of dealer paper, and dealer reserves and charge-backs.
Leasing is a recognized form of term debt financing for fixed assets. While
leases differ from loans in some respects, they are similar from a credit
viewpoint because the basic considerations are cash flow, repayment capacity,
credit history, management and projections of future operations. Additional
considerations for a lease transaction are the type of property and its
marketability in the event of default or termination of the lease. Those latter
considerations do not radically alter the manner in which an examiner evaluates
collateral for a loan. The assumption is that the lessee/borrower will generate
sufficient funds to liquidate the lease/debt. Sale of leased property/collateral
remains a secondary source of repayment and, except for the estimated residual
value at the expiration of the lease, will not, in most cases, become a factor
in liquidating the advance. When the bank is requested to purchase property of
significant value for lease, it may issue a commitment to lease, describing the
property, indicating cost, and generally outlining the lease terms. After all
terms in the lease transaction are resolved by negotiation between the bank and
its customer, an order is usually written requesting the bank to purchase the
property. Upon receipt of that order, the bank purchases the property requested
and arranges for delivery and, if necessary, installation. A lease contract is
drawn incorporating all the points covered in the commitment letter, as well as
the rights of the bank and lessee in the event of default. The lease contract is
generally signed simultaneously with the signing of the order to purchase and
the agreement to lease.
The types of assets that may be leased are numerous, and the accounting for
direct leasing is a complex subject which is discussed in detail in Financial
Accounting Standards Board (FASB) Statement Number 13. Familiarity with FASB No.
13 is a prerequisite for the management of any bank engaging in or planning to
engage in direct lease financing. The following terms are commonly encountered
in direct lease financing: (1) Net Lease, one in which the bank is not directly
or indirectly obligated to assume the expenses of maintaining the equipment.
This restriction does not prohibit the bank from paying delivery and set up
charges on the property. (2) Full Payout Lease, one for which the bank expects
to realize both the return of its full investment and the cost of financing the
property over the term of the lease. This payout can come from rentals,
estimated tax benefits, and estimated residual value of the property. (3)
Leveraged Lease, in which the bank as lessor purchases and becomes the owner of
equipment by providing a relatively small percentage (20-40%) of the capital
needed. Balance of the funds is borrowed by the lessor from long-term lenders
who hold a first lien on the equipment and assignments of the lease and lease
rental payments. This specialized and complex form of leasing is prompted mainly
by a desire on the part of the lessor to shelter income from taxation.
Creditworthiness of the lessee is paramount and the general rule is a bank
should not enter into a leveraged lease transaction with any party to whom it
would not normally extend unsecured credit. (4) Rentals, which includes only
those payments reasonably anticipated by the bank at the time the lease is
executed.
Bank management should carefully evaluate all lease variables, including the
estimate of the residual value. Banks may be able to realize unwarranted lease
income in the early years of a contract by manipulating the lease variables. In
addition, a bank can offer the lessee a lower payment by assuming an
artificially high residual value during the initial structuring of the lease.
But this technique may present the bank with serious long-term problems because
of the reliance on speculative or nonexistent residual values.
Often, lease contracts contain an option permitting the lessee to continue
use of the property at the end of the original term, working capital
restrictions and other restrictions or requirements similar to debt agreements,
and lease termination penalties. Each lease is an individual contract written to
fulfill the lessee's needs. Consequently, there may be many variations of each
of the above provisions. However, the underlying factors remain the same: there
is a definite contractual understanding of the positive right to use the
property for a specific period of time, and required payments are irrevocable.
Examination procedures for reviewing direct lease financing activities are
included in the Examination Modules Handbook in the Loan References section.
Floor plan (wholesale) lending is a form of retail goods inventory financing
in which each loan advance is made against a specific piece of collateral. As
each piece of collateral is sold by the dealer, the loan advance against that
piece of collateral is repaid. Items commonly subject to floor plan debt are
automobiles, home appliances, furniture, television and stereophonic equipment,
boats, mobile homes and other types of merchandise usually sold under a sales
finance contract. Drafting agreements are a relatively common approach utilized
in conjunction with floor plan financing. Under this arrangement, the bank
establishes a line of credit for the borrower and authorizes the manufacturer of
the goods to draw drafts on the bank in payment for goods shipped. The bank
agrees to honor these drafts, assuming proper documentation (such as invoices,
manufacturer's statement of origin, etc.) is provided. The method facilitates
inventory purchases by, in effect, guaranteeing payment to the manufacturer for
merchandise supplied. Floor plan loans involve all the basic risks inherent in
any form of inventory financing. However, because of the banker's inability to
exercise full control over the floored items, the exposure to loss may be
greater than in other similar types of financing. Most dealers have minimal
capital bases relative to debt. As a result, close and frequent review of the
dealer's financial information is necessary. As with all inventory financing,
collateral value is of prime importance. Control requires the bank to determine
the collateral value at the time the loan is placed on the books, frequently
inspect the collateral to determine its condition, and impose a curtailment
requirement sufficient to keep collateral value in line with loan balances.
Handling procedures for floor plan lines will vary greatly depending on bank
size and location, dealer size and the type of merchandise being financed. In
many cases, the term "trust receipt" is used to describe the debt instrument
existing between the bank and the dealer. Trust receipts may result from
drafting agreements between a bank and a manufacturer for the benefit of a
dealer. In other instances, the dealer may order inventory, bring titles or
invoices to the bank, and then obtain a loan secured or to be secured by the
inventory. Some banks may use master debt instruments, and others may use a
trust receipt or note for each piece of inventory. The method of perfecting a
security interest also varies from state to state. The important point is that a
bank enact realistic handling policies and ensure that its collateral position
is properly protected.
Examination procedures and examiner considerations for reviewing floor plan
lending activities are included in the Examination Modules Handbook in the Loan
References section.
Check credit is defined as the granting of unsecured revolving lines of
credit to individuals or businesses. Check credit services are provided by the
overdraft system, cash reserve system, and special draft system. The most common
is the overdraft system. In that method, a transfer is made from a
preestablished line of credit to a customer's demand deposit account when a
check which would cause an overdraft position is presented. Transfers normally
are made in stated increments, up to the maximum line of credit approved by the
bank, and the customer is notified that the funds have been transferred. In a
cash reserve system, customers must request that the bank transfer funds from
their preestablished line of credit to their demand deposit account before
negotiating a check against them. A special draft system involves the customer
negotiating a special check drawn directly against a preestablished line of
credit. In that method, demand deposit accounts are not affected. In all three
systems, the bank periodically provides its check credit customers with a
statement of account activity. Required minimum payments are computed as a
fraction of the balance of the account on the cycle date and may be made by
automatic charges to a demand deposit account.
Most bank credit card plans are similar. The bank solicits retail merchants,
service organizations and others who agree to accept a credit card in lieu of
cash for sales or services rendered. The parties also agree to a discount
percentage of each sales draft and a maximum dollar amount per transaction.
Amounts exceeding that limit require prior approval by the bank. Merchants also
may be assessed a fee for imprinters or promotional materials. The merchant
deposits the bank credit card sales draft at the bank and receives immediate
credit for the discounted amount. The bank assumes the credit risk and charges
the nonrecourse sales draft to the individual customer's credit card account.
Monthly statements are rendered by the bank to the customer who may elect to
remit the entire amount, generally without service charge, or pay in monthly
installments, with an additional percentage charged on the outstanding balance
each month. A cardholder also may obtain cash advances from the bank or
dispensing machines. Those advances accrue interest from the transaction date.
A bank may be involved in a credit card plan in three ways. (1) Agent Bank
which receives credit card applications from customers and sales drafts from
merchants and forwards such documents to banks described below, and is
accountable for such documents during the process of receiving and forwarding.
(2) Sublicensee Bank which maintains accountability for credit card loans and
merchant's accounts; may maintain its own center for processing payments and
drafts; and may maintain facilities for embossing credit cards. (3) Licensee
Bank which is the same as sublicensee bank, but in addition may perform
transaction processing and credit card embossing services for sublicensee banks,
and also acts as a regional or national clearinghouse for sublicensee banks.
A bank's policies in the areas of check credit and credit card loans should
address procedures for careful screening of account applicants; establishment of
internal controls to prevent interception of cards before delivery or merchants
from obtaining control of cards or customers from making fraudulent use of lost
or stolen cards; frequent review of delinquent accounts, accounts where payments
are made by drawing on reserves, and accounts with steady usage; delinquency
notification procedures; guidelines for realistic charge-offs; removal of
accounts from delinquent status (curing) through performance not requiring a
catchup of delinquent principal; and provisions which preclude automatic
reissuance of expired cards to obligors with charged-off balances or an
otherwise unsatisfactory credit history with the bank.
Examination procedures for reviewing these activities are included in the
Examination Modules Handbook. Separate sections on "Consumer and Check Credit"
and Credit Card Activities are included in the Loan References section of the
Handbook. Also, the FDIC has separate manuals on "Credit Card Specialty Bank
Examination Guidelines" and "Securitization Activities of Credit Card Specialty
Banks."
Merchant credit card activities basically involve the acceptance of credit
card sales drafts for clearing by a financial institution (the "Clearing
Institution"). For the Clearing Institution, these activities are generally
characterized by thin profit margins amidst high transactional and sales
volumes. Typically, a merchant's customer will charge an item on a credit card,
and the Clearing Institution will give credit to the merchant's account. Should
the customer dispute a charge transaction, the Clearing Institution is obligated
to honor the customer's legitimate request to reverse the transaction. The
Clearing Institution must then seek reimbursement from the merchant. Problems
arise when the merchant is not creditworthy and is unable, or unwilling, to
reimburse the Clearing Institution. In these instances, the Clearing Institution
will incur a loss. Examiners should review for the existence of any such
contigent liabilities. Any potential losses should be treated according to the
instructions in the Contingent Liabilities Section of this Manual.
In order to avoid losses and to ensure the safe and profitable operation of a
Clearing Institution's credit card activities, the merchants with whom it
contracts for clearing services should be financially sound and honestly
operated. To this end, safe and sound merchant credit card activities should
include clear and detailed acceptance standards for merchants. These standards
include the following:
Another possible problem with merchant activities involves Clearing
Institutions that sometimes engage the services of agents, such as an
independent sales organization ("ISO"). ISOs solicit merchants' credit card
transactions for a Clearing Institution. In some cases, the ISOs actually
contract with merchants on behalf of Clearing Institutions. Some of these
contracts are entered into by the ISOs without the review and approval of the
Clearing Institutions. At times, Clearing institutions unfortunately rely too
much on the ISOs to oversee account activity. In some cases, Clearing
Institutions have permitted ISOs to contract with disreputable merchants.
Because of the poor condition of the merchant, or ISO, or both, these Clearing
Institutions can ultimately incur heavy losses.
A financial institution with credit card clearing activities should develop
its own internal controls and procedures to ensure sound agent selection
standards before engaging an ISO. ISOs that seek to be compensated solely on the
basis of the volume of signed-up merchants should be carefully scrutinized. A
Clearing Institution should adequately supervise the ISO's activities just as
the institution should supervise any third party engaged to perform services for
any aspect of the institution's operations. Also, it should reserve the right to
ratify or reject any merchant contract that is initiated by an ISO.
Examination procedures for reviewing credit card related merchant activities
are included in the Examination Modules Handbook in the Supplemental Modules
Section.
Appraisals are professional judgments of the market value of real property.
Three basic valuation approaches are used by professional appraisers in
estimating the market value of real property the cost approach, the market data
or direct sales comparison approach, and the income approach. The principles
governing the three approaches are widely known in the appraisal field and are
referenced in parallel regulations issued by each of the federal bank and thrift
regulatory agencies. When evaluating collateral, the three valuation approaches
are not equally appropriate.
The income approach converts all expected future net operating income into
present value terms. When market conditions are stable and no unusual patterns
of future rents and occupancy rates are expected, the direct capitalization
method is often used to estimate the present value of future income streams. For
troubled properties, however, the more explicit discounted cash flow (net
present value) method is more typically utilized for analytical purposes. In the
rent method, a time frame for achieving a "stabilized", or normal, occupancy and
rent level is projected. Each year's net operating income during that period is
discounted to arrive at present value of expected future cash flows. The
property's anticipated sales value at the end of the period until stabilization
(its terminal or reversion value) is then estimated. The reversion value
represents the capitalization of all future income streams of the property after
the projected occupancy level is achieved. The terminal or reversion value is
then discounted to its present value and added to the discounted income stream
to arrive at the total present market value of the property.
When an income property is experiencing financial difficulties due to general
market conditions or due to its own characteristics, data on comparable property
sales often are difficult to obtain. Troubled properties may be hard to market,
and normal financing arrangements may not be available. Moreover, forced and
liquidation sales can dominate market activity. When the use of comparables is
not feasible (which is often the case for commercial properties), the net
present value of the most reasonable expectation of the property's
income-producing capacity - not just in today's market but over time - offers
the most appropriate method of valuation in the supervisory process.
Estimates of the property's value should be based upon reasonable and
supportable projections of the determinants of future net operating income:
rents (or sales), expenses and rates of occupancy. Judgment is involved in
estimating all of these factors. The primary considerations for these
projections include historical levels and trends, the current market performance
achieved by the subject and similar properties, and economically feasible and
defensible projections of future demand and supply conditions. To the extent
that current market activity is dominated by a limited number of transactions or
liquidation sales, high capitalization and discount rates implied by such
transactions should not be used. Rather, analysts should use rates that reflect
market conditions that are neither highly speculative nor depressed.
Title XI of the Federal Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 requires that appraisals prepared by certified or
licensed appraisers be obtained in support of real estate lending and mandates
that the Federal financial institutions regulatory agencies adopt regulations
regarding the preparation and use of appraisals in certain real estate related
transactions by financial institutions under their jurisdiction. In addition,
Title XI created the Appraisal Subcommittee (Subcommittee) of the Federal
Financial Institutions Examination Council (FFIEC) to provide oversight of the
real estate appraisal process as it relates to federally related real estate
transactions. The Subcommittee is composed of six members, each of whom is
designated by the head of their respective agencies. Each of the five financial
institution regulatory agencies which comprise the FFIEC and the U.S. Department
of Housing and Urban Development are represented on Subcommittee. A
responsibility of the Subcommittee is to monitor the State certification and
licensing of appraisers. It has the authority to disapprove a state appraiser
regulatory program, thereby disqualifying the state's licensed and certified
appraisers from conducting appraisals for federally related transactions. The
Subcommittee gets its funding by charging state certified and licensed
appraisers an annual registration fee. The fee income is used to cover
Subcommittee administrative expenses and to provide grants to the Appraisal
Foundation.
Formed in 1987, the Appraisal Foundation was established as a private not for
profit corporation bringing together interested parties within the appraisal
industry, as well as users of appraiser services, to promote professional
standards within the appraisal industry. The Foundation sponsors two independent
boards referred to in Title XI, The Appraiser Qualifications Board (AQB) and The
Appraisal Standards Board (ASB). Title XI specifies that the minimum standards
for State appraiser certification are to be the criteria for certification
issued by the AQB. Title XI does not set specific criteria for the licensed
classification. These are individually determined by each State. Additionally,
Title XI requires that the appraisal standards prescribed by the federal
Agencies, at a minimum, must be the appraisal standards promulgated by the ASB.
The ASB has issued The Uniform Standards of Professional Appraisal Practice
(USPAP) which set the appraisal industry standards for conducting an appraisal
of real estate. To the appraisal industry, USPAP is analogous to generally
accepted accounting principles for the accounting profession.
In conformance with Title XI, Part 323 of the FDIC regulations identifies
which real estate related transactions require an appraisal by a certified or
licensed appraiser and establishes minimum standards for performing appraisals.
Substantially similar regulations have been adopted by each of the federal
financial institutions regulatory agencies.
Real estate-related transactions include real estate loans, mortgage-backed
securities, bank premises, real estate investments, and other real estate owned.
All real estate-related transactions by FDIC-insured institutions not
specifically exempt are, by definition, "federally related transactions" subject
to the requirements of the regulation. Exempt real estate-related transactions
include:
(1) The transaction value is $250,000 or less;
(2) A lien on real estate has been taken as collateral in an abundance of
caution;
(3) The transaction is not secured by real estate;
(4) A lien on real estate has been taken for purposes other than the real
estate's value;
(5) The transaction is a business loan that: (i) Has a transaction value of
$1 million or less; and (ii) Is not dependent on the sale of, or rental income
derived from, real estate as the primary source of repayment;
(6) A lease of real estate is entered into, unless the lease is the economic
equivalent of a purchase or sale of the leased real estate;
(7) The transaction involves an existing extension of credit at the lending
institution, provided that: (i) There has been no obvious and material change in
the market conditions or physical aspects of the property that threatens the
adequacy of the institution's real estate collateral protection after the
transaction, even with the advancement of new monies; or (ii) There is no
advancement of new monies, other than funds necessary to cover reasonable
closing costs;
(8) The transaction involves the purchase, sale, investment in, exchange of,
or extension of credit secured by, a loan or interest in a loan, pooled loans,
or interests in real property, including mortgage-backed securities, and each
loan or interest in a loan, pooled loan, or real property interest met FDIC
regulatory requirements for appraisals at the time of origination;
(9) The transaction is wholly or partially insured or guaranteed by a United
States government agency or United States government sponsored agency;
(10) The transaction either; (i) Qualifies for sale to a United States
government agency or United States government sponsored agency; or (ii) Involves
a residential real estate transaction in which the appraisal conforms to the
Federal National Mortgage Association or Federal Home Loan Mortgage Corporation
appraisal standards applicable to that category of real estate;
(11) The regulated institution is acting in a fiduciary capacity and is not
required to obtain an appraisal under other law; or
(12) The FDIC determines that the services of an appraiser are not necessary
in order to protect Federal financial and public policy interests in real
estate-related financial transaction or to protect the safety and soundness of
the institution.
Section 323.4 establishes minimum standards for all appraisals in connection
with federally related transactions. All appraisals performed in conformance
with the regulation must conform to the requirements of the USPAP and certain
other listed standards. The applicable sections of USPAP are the Preamble
(ethics and competency), Standard 1 (appraisal techniques), Standard 2 (report
content), and Standard 3 (review procedures). USPAP Standards 4 through 10
concerning appraisal services and appraising personal property do not apply to
federally related transactions.
An appraisal satisfies the regulation if it is performed in accordance with
all of its provisions and it is still current and meaningful. In other words, a
new appraisal does not necessarily have to be done every time there is a
transaction, provided the institution has an acceptable process in place to
review existing appraisals.
Adherence to the appraisal regulation and appraisal guidelines should be part
of the examiner's overall review of the lending function. An institution's
written appraisal program should contain specific administrative review
procedures that provide some evidence, such as a staff member's signature on an
appraisal checklist, that indicates the appraisal was reviewed and that all
standards were met. In addition, the regulation requires that the appraisal
contain the appraiser's certification that it was prepared in conformance with
USPAP. When analyzing individual transactions, examiners should review appraisal
reports to determine the institution's conformity to its own internal appraisal
policies and for compliance with the regulation. Examiners may need to conduct a
more detailed review if the appraisal does not have sufficient information, does
not explain assumptions, is not logical, or has other major deficiencies that
cast doubt as to the validity of its opinion of value. Examination procedures
regarding appraisal reviews are included in the Examination Modules Handbook in
the Loan Portfolio Management and Review Section.
Loans in a pool such as an investment in mortgage- backed securities or
collateralized mortgage obligations should have some documented assurance that
each loan in the pool has an appraisal in accordance with the regulation.
Appropriate evidence could include an issuer's certification of compliance.
All violations of Part 323 should be listed in the examination report in the
usual manner. Significant systemic failures to meet standards and procedures
could call for formal corrective measures.
These guidelines (which were last issued on October 27, 1994) address
supervisory matters relating to real estate-related financial transactions and
provide guidance to examining personnel and federally regulated institutions
about prudent appraisal and evaluation policies, procedures, practices, and
standards.
When analyzing individual transactions, examiners will review an appraisal or
evaluation to determine whether the methods, assumptions, and findings are
reasonable and in compliance with the agencies' appraisal regulations, policies,
supervisory guidelines, and the institution's policies. Examiners also will
review the steps taken by an institution to ensure that the individuals who
perform its appraisals and evaluations are qualified and are not subject to
conflicts of interest. Institutions that fail to maintain a sound appraisal or
evaluation program or to comply with the agencies' appraisal regulations,
policies, or these supervisory guidelines will be cited in examination reports
and may be criticized for unsafe and unsound banking practices. Deficiencies
will require corrective action.
Under the agencies' appraisal regulations, the appraiser must be selected and
engaged directly by the institution or its agent. The appraiser's client is the
institution, not the borrower. An institution may use an appraisal that was
prepared by an appraiser engaged directly by another financial services
institution, as long as the institution determines that the appraisal conforms
to the agencies' appraisal regulations and is otherwise acceptable.
The agencies recognize, however, that it is not always possible or practical
to separate the loan and collection functions from the appraisal or evaluation
process. In some cases, such as in a small or rural institution or branch, the
only individual qualified to analyze the real estate collateral may also be a
loan officer, other officer, or director of the institution. To ensure their
independence, such lending officials, officers, or directors should abstain from
any vote or approval involving loans on which they performed an appraisal or
evaluation.
Although allowed by USPAP, the agencies' appraisal regulations do not
permit an appraiser to appraise any property in which the appraiser has an
interest, direct or indirect, financial or otherwise. As discussed below, appraisers have available various appraisal development
and report options; however, not all options may be appropriate for all
transactions. A report option is acceptable under the agencies' appraisal
regulations only if the appraisal report contains sufficient information and
analysis to support an institution's decision to engage in the transaction.
This standard is designed to avoid having appraisals prepared using
unrealistic assumptions and inappropriate methods. For federally related
transactions, an appraisal is to include the current market value of the
property in its actual physical condition and subject to the zoning in effect as
of the date of the appraisal. For properties where improvements are to be
constructed or rehabilitated, the regulated institution may also request a
prospective market value based on stabilized occupancy or a value based on the
sum of retail sales. However, the sum of retail sales for a proposed development
is not the market value of the development for the purpose of the agencies'
appraisal regulations. For proposed developments that involve the sale of
individual houses, units, or lots, the appraiser must analyze and report
appropriate deductions and discounts for holding costs, marketing costs and
entrepreneurial profit. For proposed and rehabilitated rental developments, the
appraiser must make appropriate deductions and discounts for items such as
leasing commission, rent losses, and tenant improvements from an estimate based
on stabilized occupancy.
An institution may engage an appraiser to perform either a Complete or
Limited Appraisal. When performing a Complete Appraisal assignment, an appraiser
must comply with all USPAP standards without departing from any binding
requirements and specific guidelines when estimating market value. When
performing a Limited Appraisal, the appraiser elects to invoke the Departure
Provision which allows the appraiser to depart, under limited conditions, from
standards identified as specific guidelines. For example, in a Limited
Appraisal, the appraiser might not utilize all three approaches to value;
however, departure from standards designated as binding requirements is not
permitted. There are numerous binding requirements which are detailed in the
USPAP. Use of the USPAP Standards publication as a reference is recommended. The
book provides details on each appraisal standard and advisory opinions issued by
the Appraisal Standards Board.
An institution and appraiser must concur that use of the Departure Provision
is appropriate for the transaction before the appraiser commences the appraisal
assignment. The appraiser must ensure that the resulting appraisal report will
not mislead the institution or other intended users of the appraisal report. The
agencies do not prohibit the use of a Limited Appraisal for a federally related
transaction, but the agencies believe that institutions should be cautious in
their use of a Limited Appraisal because it will be less thorough than a
Complete Appraisal.
Complete and Limited Appraisal assignments may be reported in three different
report formats: a Self-Contained Report, a Summary Report, or a Restricted
Report. The major difference among these three reports relates to the degree of
detail presented in the report by the appraiser. The Self-Contained Appraisal
Report provides the most detail, while the Summary Appraisal Report presents the
information in a condensed manner. The Restricted Report provides a capsulated
report with the supporting details maintained in the appraiser's files.
The agencies believe that the Restricted Report format will not be
appropriate to underwrite a significant number of federally related transactions
due to the lack of sufficient supporting information and analysis in the
appraisal report. However, it might be appropriate to use this type of appraisal
report for ongoing collateral monitoring of an institution's real estate
transactions and under other circumstances when an institution's program
requires an evaluation.
Moreover, since the institution is responsible for selecting the appropriate
appraisal report to support its underwriting decisions, its program should
identify the type of appraisal report that will be appropriate for various
lending transactions. The institution's program should consider the risk, size,
and complexity of the individual loan and the supporting collateral when
determining the level of appraisal development and the type of report format
that will be ordered. When ordering an appraisal report, institutions may want
to consider the benefits of a written engagement letter that outlines the
institution's expectations and delineates each party's responsibilities,
especially for large, complex, or out-of-area properties.
Institutions should also establish criteria for obtaining appraisals or
evaluations for safety and soundness reasons for transactions that are otherwise
exempt from the agencies' appraisal regulations.
An evaluation report should include calculations, supporting assumptions,
and, if utilized, a discussion of comparable sales. Documentation should be
sufficient to allow an institution to understand the analysis, assumptions, and
conclusions. An institution's own real estate loan portfolio experience and
value estimates prepared for recent loans on comparable properties might provide
a basis for evaluations.
An evaluation should provide an estimate of value to assist the institution
in assessing the soundness of the transaction. Prudent practices also require
that as an institution engages in more complex real estate-related financial
transactions, or as its overall exposure increases, a more detailed evaluation
should be performed. For example, an evaluation for a home equity loan might be
based primarily on information derived from a sales data services organization
or current tax assessment information, while an evaluation for an
income-producing real estate property should fully describe the current and
expected use of the property and include an analysis of the property's rental
income and expenses.
The decision to reappraise or reevaluate the real estate collateral should be
guided by the exemption for renewals, refinancings, and other subsequent
transactions. Loan workouts, debt restructurings, loan assumptions, and similar
transactions involving the addition or substitution of borrowers may qualify for
the exemption for renewals, refinancings, and other subsequent transactions. Use
of this exemption depends on the condition and quality of the loan, the
soundness of the underlying collateral and the validity of the existing
appraisal or evaluation.
A reappraisal would not be required when an institution advances funds to
protect its interest in a property, such as to repair damaged property, because
these funds should be used to restore the damaged property to its original
condition. If a loan workout involves modification of the terms and conditions
of an existing credit, including acceptance of new or additional real estate
collateral, which facilitates the orderly collection of the credit or reduces
the institution's risk of loss, a reappraisal or reevaluation may be prudent,
even if it is obtained after the modification occurs.
An institution may engage in a subsequent transaction based on documented
equity from a valid appraisal or evaluation, if the planned future use of the
property is consistent with the use identified in the appraisal or evaluation.
If a property, however, has reportedly appreciated because of a planned change
in use of the property, such as rezoning, an appraisal would be required for a
federally related transaction, unless another exemption applied.
An institution's appraisal and evaluation program should also have
comprehensive analytical procedures that focus on certain types of loans, such
as large-dollar credits, loans secured by complex or specialized properties,
non-residential real estate construction loans, or out-of-area real estate.
These comprehensive analytical procedures should be designed to verify that the
methods, assumptions, and conclusions are reasonable and appropriate for the
transaction and the property. These procedures should provide for a more
detailed review of selected appraisals and evaluations prior to the final credit
decision. The individual(s) performing these reviews should have the appropriate
training or experience, and be independent of the transaction.
Appraisers and persons performing evaluations should be responsible for any
deficiencies in their reports. Deficient reports should be returned to them for
correction. Unreliable appraisals or evaluations should be replaced prior to the
final credit decision. Changes to an appraisal's estimate of value are permitted
only as a result of a review conducted by an appropriately qualified State
licensed or certified appraiser in accordance with Standard III of USPAP.
All apparent violations of the appraisal regulation should be described in
the schedule of violations of laws and regulations. Management's comments and
any commitments for correcting the practices that led to the apparent violation
should be included. Violations that are technical in nature and do not impact
the value conclusion generally should not require a new appraisal. (These
technical violations should not be relisted in subsequent examinations.) Since
the point of an appraisal is to help make sound loan underwriting decisions,
getting an appraisal on a loan already made, simply to fulfill the requirements
of the appraisal regulation, would be of little benefit. However, an institution
should be expected to obtain a new appraisal on a loan in violation of the
appraisal regulation when there is a safety and soundness reason for such
action. For example, construction loans and lines of credit need to have the
value of the real estate reviewed frequently in order for the institution to
properly manage the credit relationship. It might also be, that for supervisory
purposes, a new appraisal might be needed to determine the proper classification
for examination purposes of a collateral dependent loan.
A loan participation is a sharing or selling of ownership interests in a loan
between two or more financial institutions. Normally, a lead bank originates the
loan and sells ownership interests to one or more participating banks at the
time the loan is closed. The lead bank (originating bank) normally retains a
partial interest in the loan, holds all loan documentation in its own name,
services the loan, and deals directly with the customer for the benefit of all
participants. Properly structured, loan participations allow selling banks to
accommodate large loan requests which would otherwise exceed lending limits,
diversify risk, and improve liquidity or obtain additional lendable funds.
Participating banks are able to compensate for low local loan demand or invest
in large loans without servicing burdens and origination costs. If not
appropriately structured and documented, a participation loan can present
unwarranted risks to both the seller and purchaser of the loan. Examiners should
determine the nature and adequacy of the participation arrangement as well as
analyze the credit quality of the loan.
In determining the true recourse nature of a participation, examiners must
determine the extent to which the credit risk has been transferred from the lead
bank to the participant. In general, if the risk of loss or obligation for
payments of principal or interest is retained by, or may ultimately fall back
upon, the seller or lead bank, the transaction must be reported by the seller as
a borrowing from the purchaser and by the purchaser as a loan to the seller.
Complete details on treatment of participation loans for reporting purposes are
found in the Glossary for Call Report Instructions under the caption "Sales of
Assets."
During the life of the participation, the participant should monitor the
servicing and the status of the loan. In order to exercise control of its
ownership interest, a purchasing bank must ascertain that the selling bank will
provide complete and timely credit information on a continuing basis.
The procedures for purchasing loan participations should be provided for in
the bank's formal lending policy. The criteria for participation loans should be
consistent with that for similar direct loans. The policy would normally require
the complete analysis of the credit quality of obligations to be purchased,
determination of value and lien status of collateral, and the maintenance of
full credit information for the life of the participation.
In some loan participation arrangements, the participation agreement provides
for the allocation of loan payments on some basis other than in proportion to
ownership interest; e.g., principal payments may be applied first to the
participant's ownership interest and all remaining payments to the lead bank's
ownership interest. In these instances, the participation agreement must also
specify that in case of loan default, participants will share in all subsequent
payments and collections in proportion to their respective ownership interests
at the time of default. Without such a provision, the banks would not have a pro
rata sharing of credit risk and participations thus sold would have to be
considered as borrowings for examination and reporting purposes.
In some cases, depository institutions structure loan originations and
participations with the intention of selling off 100% of the underlying loan
amount. Certain 100% loan participation programs raise unique safety and
soundness issues that should be addressed by an institution's policies,
procedures and practices. An interagency policy statement on this topic was
issued by a press release dated April 23, 1997 to provide uniform guidance for
depository institutions that structure these 100% loan participation programs.
If not appropriately structured, these 100% participation programs can
present unwarranted risks to the originating institution including legal,
reputation and compliance risks. While this statement applies only to a small
number of mostly very large insured depository institutions, the agreements
should clearly state the limitations the originating and participating
institutions impose on each other and the rights all parties retain. The
originating institution should state that loan participants are participating in
loans and are not investing in a business enterprise. The policies of an
institution engaged in these originations should address safety and soundness
concerns and include criteria to address:
A lending institution should have in place appropriate safeguards and
controls to limit exposure to potential environmental liability associated with
real property held as collateral. The FDIC has issued "Guidelines for an
Environmental Risk Program" to FDIC-supervised institutions which urges those
institutions to establish environmental risk programs tailored to the level of
risk in their lending and investment activities. These guidelines are as
follows:
The potential adverse effect of environmental contamination on the value of
real property and the potential for liability under various environmental laws
have become important factors in evaluating real estate transactions and making
loans secured by real estate. Environmental contamination, and liability
associated with environmental contamination, may have a significant adverse
effect on the value of real estate collateral, which may in certain
circumstances cause an insured institution to abandon its right to the
collateral. It is also possible for an institution to be held directly liable
for the environmental cleanup of real property collateral acquired by the
institution. The cost of such a cleanup may exceed by many times the amount of
the loan made to the borrower. A loan may be affected adversely by potential
environmental liability even where real property is not taken as collateral. For
example, a borrower's capacity to make payments on a loan may be threatened by
environmental liability to the borrower for the cost of a hazardous
contamination cleanup on property unrelated to the loan with the institution.
The potential for environmental liability may arise from a variety of federal
and state environmental laws and from common law tort liability.
As part of the institution's overall decision-making process, the
environmental risk program should establish procedures for identifying and
evaluating potential environmental concerns associated with lending practices
and other actions relating to real property. The board of directors should
review and approve the program and designate a senior officer knowledgeable in
environmental matters responsible for program implementation. The environmental
risk program should be tailored to the needs of the lending institution. That
is, institutions that have a heavier concentration of loans to higher risk
industries or localities of known contamination may require a more elaborate and
sophisticated environmental risk program than institutions that lend more to
lower risk industries or localities. The environmental risk program should
provide for staff training, set environmental policy guidelines and procedures,
require an environmental review or analysis during the application process,
include loan documentation standards, and establish appropriate environmental
risk assessment safeguards in loan workout situations and foreclosures.
Examiners should review an institution's environmental risk program as part
of the examination of its lending and investment activities. When analyzing
individual credits, examiners should review the institution's compliance with
its own environmental risk program. Failure to establish or comply with an
appropriate environmental program should be criticized and corrective action
required.
It would be impossible to enumerate all sources and causes of problem loans.
They cover a multitude of mistakes a bank may permit a borrower to make, as well
as mistakes directly attributable to weaknesses in the bank's credit
administration and management. Some well-constructed loans may develop problems
due to unforeseen circumstances on the part of the borrower, however, bank
management must endeavor to protect a loan by every means possible. One or more
of the items in the following list is often basic to the development of loan
problems.
Many of these items may also be indicative of potential bank fraud and/or
insider abuse. Additional information on the warning signs and suggested areas
for investigation are included in the Bank Fraud and Insider Abuse Section of
this Manual.
Problems in this area may reflect the absence of sound lending policies,
and/or management's lack of sound credit judgment in advancing certain loans.
The following are general types of loans which may fall within the category of
poor risk selection. It should be kept in mind that these examples are
generalizations, and the examiner must weigh all relevant factors in determining
whether a given loan is indeed a poor risk.
It is almost as serious, from the standpoint of ultimate losses, to lend a
sound financial risk too much money as it is to lend to an unsound risk. Loans
beyond the reasonable capacity of the borrower to repay invariably lead to the
development of problem loans.
Loans granted without a well-defined repayment program violate a fundamental
principle of sound lending. Regardless of what appears to be adequate collateral
protection, failure to establish at inception or thereafter enforce a program of
repayment almost invariably leads to troublesome and awkward servicing problems,
and in many instances is responsible for serious loan problems including
eventual losses. This axiom of sound lending is important not only from the
lender's standpoint, but also the borrower's.
Lending errors frequently result because of management's failure to obtain
and properly evaluate credit information. Adequate and comparative financial
statements, income statements, cash flow statements and other pertinent
statistical support should be available. Other essential information, such as
the purpose of the borrowing and intended plan or sources of repayment, progress
reports, inspections, memoranda of outside information and loan conferences,
correspondence, etc., should be contained in the bank's credit files. Failure of
a bank's management to give proper attention to credit files makes sound credit
judgment difficult if not impossible.
Misplaced emphasis upon loan income, rather than soundness, almost always
leads to the granting of loans possessing undue risk. In the long run, unsound
loans usually are far more expensive than the amount of revenue they may
initially produce.
Pronounced self-dealing practices are almost always present in serious
problem bank situations and in banks which fail. Such practices with regard to
loans are found in the form of overextensions of credit on an unsound basis to
insiders, or their interests, who have improperly used their positions to obtain
unjustified loans. Active officers, who serve at the pleasure of the ownership
interests, are often subjected to pressures which make it difficult to
objectively evaluate such loans. Loans made for the benefit of ownership
interests which may be actually carried in the name of a seemingly unrelated
party are sometimes used to conceal self-dealing loans.
Technical incompetence usually is manifested in management's inability to
obtain and evaluate credit information and put together a well-conceived loan
package. Management weaknesses in this area are almost certain to lead to
eventual loan losses. Problems can also develop when management, technically
sound in some forms of lending, becomes involved in specialized types of credit
in which it lacks expertise and experience.
Loan problems encountered in this area normally arise for one of two reasons:
(1) Absence of effective active management supervision of loans which possessed
reasonable soundness at inception. Ineffective supervision almost invariably
results from lack of knowledge of a borrower's affairs over the life of the
loan. It may well be coupled with one or more of the causes and sources of loan
problems previously mentioned. (2) Failure of the board and/or senior management
to properly oversee subordinates to determine that sound policies are being
carried out.
Economic conditions, both national and local, are continuously changing, and
a bank's management must be responsive to these changes. This is not to suggest
that a bank's lending policies should be in a constant state of flux, nor does
it suggest that management should be able to forecast totally the results of
economic changes. It does mean, however, that bankers should realistically
evaluate lending policies and individual loans in light of changing conditions.
Economic downturns can adversely affect borrowers' repayment potential and can
lessen a bank's collateral protection. Reliance on previously existing
conditions as well as optimistic hopes for economic improvement can,
particularly when coupled with one or more of the causes and sources of loan
problems previously mentioned, lead to serious loan portfolio deterioration.
Competition among financial institutions for growth, profitability, and
community influence sometimes results in the compromise of sound credit
principles and acquisition of unsound loans. The ultimate cost of unsound loans
outweighs temporary gains in growth, income and influence.
The preceding discussions describe various practices or conditions which may
serve as a source or cause of weak loans. Weak loans resulting from these
practices or conditions may manifest themselves in a variety of ways. While it
is impossible to provide a complete detailing of potential "trouble indicators",
the following list, by document, may aid the examiner in identifying potential
problem loans during the appraisal process.
In order to properly analyze any credit, an examiner must acquire certain
fundamental information about a borrower's financial condition, purpose and
terms of the borrowing, and prospects for its orderly repayment. The process
involved in acquiring the foregoing information will necessarily vary with the
size of the bank under examination and the type and sophistication of records
utilized by the bank.
Because of the sheer volume of loans, it is necessary to focus attention on
the soundness of larger lines of credit. Relatively smaller loans that appear to
be performing satisfactorily may ordinarily be omitted from individual
appraisal. The minimum size of the loan to be appraised depends upon the
characteristics of the individual bank. The cut-off point should be low enough
to permit an accurate appraisal of the loan portfolio as a whole, yet not so
high as to preclude a thorough analysis of a representative portion of total
loans. This procedure does not prevent an examiner from analyzing smaller loans
which are steady for long periods of time, overdue, deficient in collateral
coverage, or otherwise possess characteristics which would cause them to be
subject to further scrutiny. In most instances, there should be direct
correlation between the cut-off point utilized, the percentage of loans lined,
and the asset quality and management ratings assigned at the previous
examination.
The following types of loans or lines of credit should be analyzed at each
examination:
The degree of analysis and/or time devoted to the above loans may vary. For
example, the time devoted to a previously classified loan which has been
substantially reduced or otherwise improved may be significantly less than other
loans. "Watch List" loans should initially be sampled to assess if management's
ratings are accurate. The reworking of certain loan files, such as seasoned real
estate mortgages which are not subject to significant change, should be kept to
a minimum or omitted. This does not mean that an examiner should not briefly
review new file information (since the previous examination) to determine any
adverse trends with respect to significant loans. In addition, the examiner
should review a sufficient volume of different types of loans offered by the
bank to determine that bank policies are adequate and being followed.
Commercial loan liability ledgers or comparable subsidiary records vary
greatly in quality and detail. Generally, they will provide the borrower's total
commercial loan liability to the bank, and the postings thereto will depict a
history of the debt. Collateral records should be scrutinized to acquire the
necessary descriptive information and to ascertain that the collateral held to
secure the notes is as transcribed.
Gathering credit information is an important process and should be done with
care to obtain the essential information which will enable the examiner to
appraise the loans accurately and fairly. Failure to obtain and record pertinent
information contained in the credit files can reflect unfavorably on examiners,
and a good deal of examiner and loan officer time can be saved by carefully
analyzing the files. Ideally, credit files will also contain important
correspondence between the bank and the borrower. However, this is not
universally the case; in some instances, important correspondence is
deliberately lodged in separate files because of its sensitive character.
Correspondence between the bank and the borrower can be especially valuable to
the examiner in developing added insight into the status of problem credits.
Verification of loan proceeds is one of the most valuable and effective loan
examining techniques available to the examiner and often one of the most
ignored. This verification process can disclose fraudulent or fictitious notes,
misapplication of funds, loans made for the benefit or accommodation of parties
other than the borrower of record, or utilization of loans for purposes other
than those reflected in the bank's files. Verification of the disbursement of a
selected group of large or unusual loans, particularly those subject to
classification or special mention and those granted under circumstances which
appear illogical or incongruous is important. However, it is more important to
carry the verification process one step further to the apparent utilization of
loan proceeds as reflected by the customer's deposit account or other related
bank records. The examiner should also determine the purpose of the credit and
the expected source of repayment.
Examination Procedures regarding loan portfolio analysis are included in the
Examination Modules Handbook in the Loan Portfolio Management and Review
Section.
The examiner must comprehensively review all data collected on the individual
loans. In most banks, this review should allow the majority of loans to be
passed without criticism, obviating the need for discussing these lines with the
appropriate bank officer(s). No matter how thoroughly the bank's supporting loan
files have been reviewed, there will invariably be a number of loans which will
require additional information or discussion before an appropriate judgment can
be made as to their credit quality, relationship to other loans, proper
documentation, or other circumstances related to the overall examination of the
loan portfolio. Such loans require discussion with the appropriate bank
officer(s) as do other loans for which adequate information has been assembled
to indicate that classification or special mention is warranted.
Proper preparation for the loan discussion is essential, and the following
points should be given due consideration by the examiner. Loans which have been
narrowed down for discussion should be reviewed in depth to insure a
comprehensive grasp of all factual material. Careful advance preparation can
save time for all concerned. Particularly with regard to large, complicated
lines, undue reliance should not be placed on memory to cover important points
in loan discussion. Important weaknesses and salient points to be covered in
discussion, questions to be asked, and information to be sought should be noted.
The loan discussion should not involve discussion of trivialities since the
banker's time is valuable, and it is no place for antagonistic remarks and snide
comments directed at loan officers. The examiner should listen carefully to what
the banker has to say, and concisely and accurately note this information.
Failure to do so can result in inaccuracies and make follow-up at the next
examination more difficult.
In the appraisal of individual loans, the examiner should weigh carefully the
information obtained and arrive at a judgment as to the credit quality of the
loans under review. Each loan is appraised on the basis of its own
characteristics. Consideration is given to the risk involved in the project
being financed; the nature and degree of collateral security; the character,
capacity, financial responsibility, and record of the borrower; and the
feasibility and probability of its orderly liquidation in accordance with
specified terms. The willingness and ability of a debtor to perform as agreed
remains the primary measure of the risk of the loan. This implies that the
borrower must have earnings or liquid assets sufficient to meet interest
payments and provide for reduction or liquidation of principal as agreed at a
reasonable and foreseeable date. However, it does not mean that borrowers must
at all times be in a position to liquidate their loans, for that would defeat
the original purpose of extending credit.
Following analysis of specific credits, it is important that the examiner
ascertain whether troublesome loans result from inadequate lending and
collection policies and practices or merely reflect exceptions to basically
sound credit policies and practices. In instances where troublesome loans exist
due to ineffective lending practices and/or inadequate supervision, it is quite
possible that existing problems will go uncorrected and further loan quality
deterioration may occur. Therefore, the examiner should not only identify
problem loans, but also ascertain the cause(s) of these problems. Weaknesses in
lending policies or practices should be stressed, along with possible corrective
measures, in discussions with the bank's senior management and/or the
directorate and in the Risk Management and the Examination Conclusions and
Comments schedules.
To quantify and communicate the results of the loan appraisal, the examiner
must arrive at a decision as to which loans are to be subjected to criticism
and/or comment in the examination report. Adversely classified loans are
allocated on the basis of risk to three categories:
Other loans of questionable quality, but involving insufficient risk to
warrant classification, are designated as Special Mention loans. Loans lacking
technical or legal support, whether or not adversely classified, should be
brought to the attention of the bank's management. If the deficiencies in
documentation are severe in scope or volume, a schedule of such loans should be
included in the report of examination.
Loan classifications are expressions of different degrees of a common factor,
risk of nonpayment. All loans involve some risk, but the degree varies greatly.
It is incumbent upon examiners to avoid classification of sound loans. The
practice of lending to sound businesses or individuals for reasonable periods is
a legitimate banking function. Adverse classifications should be confined to
those loans which are unsafe for the investment of depositors' funds.
If the internal grading system is determined to be accurate and reliable,
examiners can use the institution's data for preparing the applicable
examination report pages and schedules, for determining the overall level of
classifications, and for providing supporting comments regarding the quality of
the loan portfolio. If the internal classifications are overly conservative,
examiners should make appropriate adjustments and include explanations in the
report's comments.
A revised statement on classification of bank assets and appraisal of
securities in bank examinations was issued jointly on May 7, 1979, by the
Comptroller of the Currency, the Federal Deposit Insurance Corporation, the
Federal Reserve Board, and the Conference of State Bank Supervisors. This
statement, a revision of an agreement issued in 1938 and revised July 15, 1949,
clarifies definitions and eliminates practices duplicated elsewhere. It provides
expanded definitions of "Substandard", "Doubtful", and "Loss" categories used
for adversely classifying bank assets. Amounts classified "Loss" should be
promptly eliminated from the bank's books.
Uniform guidelines have been established by the Division regarding the
examination report treatment of assets classified "Doubtful". The general policy
is not to require charge-off or similar action for Doubtful. Examiners should
make a statement calling for a bank to charge-off a portion of loans classified
Doubtful only when State law or policy requires. Further, any such statement
should be clear as to its intended purpose of bringing the bank into conformity
with those State requirements. An exception is made for formal actions under
Section 8 of the FDI Act. A statement addressing the chargeoff of loans
classified Loss is a required comment on the Examination Conclusions and
Comments schedule when the amount is material.
There is a close relationship between classifications, and no classification
category should be viewed as more important than the other. The uncollectibility
aspect of Doubtful and Loss classifications makes their segregation of obvious
importance. The function of the Substandard classification is to indicate those
loans which are unduly risky and may be a future hazard to the bank's solvency.
No bank can safely hold a large amount of low quality loans, even though they
are not presently subject to either a Doubtful or Loss classification.
A complete list of adversely classified loans is to be provided management,
either during or at the close of an examination. This is especially true in
those situations when total asset classifications amount to 25% or less of a
bank's Tier 1 capital and the examination discloses no material problems or
trends in the area of loan administration.
In these instances, the Assets Subject to Adverse Classification schedule may
be deleted.
Definition - A Special Mention asset has potential weaknesses that
deserve management's close attention. If left uncorrected, these potential
weaknesses may result in deterioration of the repayment prospects for the asset
or in the institution's credit position at some future date. Special Mention
assets are not adversely classified and do not expose an institution to
sufficient risk to warrant adverse classification.
Ordinarily, Special Mention credits have characteristics which corrective
management action would remedy. Often the bank's weak origination and/or
servicing policies are the cause for the Special Mention designation. Examiners
should not misconstrue the fact that most Special Mention loans contain
management correctable deficiencies to mean that loans involving merely
technical exceptions belong in this category. However, instances may be
encountered where technical exceptions are a factor in scheduling loans for
Special Mention.
Careful identification of loans which properly belong in this category is
important in determining the extent of risk in the bank's loan portfolio and
providing constructive criticism for bank management. While Special Mention
Assets should not be combined with adversely classified assets in reports of
examination, their total should be considered in the analysis of asset quality
and management, as appropriate.
The nature of this category precludes inclusion of smaller lines of credit
unless those loans are part of a large grouping listed for related reasons.
Comments on loans listed for Special Mention in the Report of Examination should
be drafted in a fashion similar to those for adversely classified loans. There
is no less of a requirement upon the examiner to record clearly the reasons why
the loan is listed. The major thrust of the comments should be in the direction
of achieving correction of the deficiencies identified.
Additional classification guidelines have been developed to aid the examiner
in classifying troubled commercial real estate loans. These guidelines are
intended to supplement the uniform guidelines discussed above. After performing
an analysis of the project and its appraisal, the examiner must determine the
classification of any exposure.
The following guidelines are to be applied in instances where the obligor is
devoid of other reliable means of repayment, with support of the debt provided
solely by the project. If other types of collateral or other sources of
repayment exist, the project should be evaluated in light of these mitigating
factors.
Deficiencies in documentation of loans should be brought to the attention of
management for remedial action. Failure of management to effect corrections may
lead to the development of greater credit risk in the future. Moreover, the
presence of an excessive number of technical exceptions is a reflection on
management's quality and ability. Inclusion of the schedule "Assets With Credit
Data or Collateral Documentation Exceptions" and various comments in the report
of examination is appropriate in certain circumstances. Refer to the Report of
Examination Instructions for further guidance.
Overdue loans are not necessarily subject to adverse criticism. Nevertheless,
a high volume of overdue loans almost always indicates liberal credit standards,
weak servicing practices, or both. Because loan renewal and extension policies
vary among banks, comparison of their delinquency ratios may be misleading. A
more significant method of evaluating this factor lies in determination of the
trend within the bank under examination, keeping in mind the distortion
resulting from seasonal influences, economic conditions, or the timing of
examinations. It is important for the examiner to carefully consider the makeup
and reasons for the volume of overdue loans. Only then can it be determined
whether the volume of past due paper is a significant factor reflecting
adversely on the quality or soundness of the overall loan portfolio or the
efficiency and quality of management. It is important that overdue loans be
computed on a uniform basis. This allows for comparison of overdue totals
between examinations and/or with other banks.
The report of examination includes information on overdue and nonaccrual
loans. Loans which are still accruing interest but are past their maturity or on
which either interest or principal is due and unpaid (including unplanned
overdrafts) are separated by loan type into two distinct groupings: (1) 30 to 89
days past due; (2) 90 or more days past due. Nonaccrual loans may include both
current and past due loans. In the case of installment credit, a loan will not
be considered overdue until at least two monthly payments are delinquent. The
same will apply to real estate mortgage loans, term loans or any other loans
payable on regular monthly installments of principal and/or interest.
Some modification of the overdue criteria may be necessary because of
applicable State law, joint examinations, or unusual circumstances surrounding
certain kinds of loans or in individual loan situations. It will always be
necessary for the examiner to ascertain the bank's renewal and extension
policies and procedures for collecting interest prior to determining which loans
are overdue, since such practices often vary considerably from bank to bank.
This is important not only to validate which loans are actually overdue, but
also to evaluate the soundness of such policies. Standards for renewal should be
aimed at achieving an orderly liquidation of loans and not at maintaining a low
ratio of past due paper through unwarranted extensions or renewals.
In larger departmentalized banks or banks with large branch systems, it may
be informative to analyze delinquencies by determining the source of overdue
loans by department or branch. This is particularly true if a large volume of
overdue loans should exist. The production of schedules reflecting overdue loans
by department or branch is encouraged if it will aid in pinpointing the source
of a problem or be informative from the standpoint of supervision of the bank.
Continuing to accrue income on assets which are in default as to principal
and interest overstates a bank's assets, earnings and capital. Instructions for
the Preparation of Reports of Condition and Income indicate, in summary, that
where the period of default of principal or interest equals or exceeds 90 days,
the accruing of income should be discontinued unless the asset is well-secured
and in process of collection. Banks are strongly recommended to follow this
guideline not only for reporting purposes but also bookkeeping purposes. There
are several exceptions, modifications and clarifications to this general
standard. First, consumer loans and real estate loans secured by one-to-four
family residential properties are exempt from the nonaccrual guidelines.
Nonetheless, these exempt loans should be subject to other alternative methods
of evaluation to assure the bank's net income is not materially overstated.
Second, any State statute, regulation or rule which imposes more stringent
standards for nonaccrual of interest should take precedence over these
instructions. Third, reversal of previously accrued but uncollected interest
applicable to any asset placed in a nonaccrual status, and treatment of
subsequent payments as either principal or interest, should be handled in
accordance with generally accepted accounting principles. Acceptable accounting
treatment includes reversal of all previously accrued but uncollected interest
against appropriate income and balance sheet accounts.
Finally, a debt is "well-secured" if collateralized by liens on or pledges of
real or personal property, including securities, that have a realizable value
sufficient to discharge the debt in full; or by the guarantee of a financially
responsible party. A debt is "in process of collection" if collection is
proceeding in due course either through legal action, including judgment
enforcement procedures, or, in appropriate circumstances, through collection
efforts not involving legal action which are reasonably expected to result in
repayment of the debt or its restoration to a current status.
The following guidance applies to borrowers who have resumed paying the full
amount of scheduled contractual interest and principal payments on loans that
are past due and in nonaccrual status. Although prior arrearage may not have
been eliminated by payments from the borrowers, the borrower may have
demonstrated sustained performance over a period of time in accordance with the
contractual terms. Beginning in 1993, the regulators permitted such loans to be
returned to accrual status, even though the loans have not been brought fully
current, provided two criteria are met:
When the regulatory reporting criteria for restoration to accrual status are
met, previous charge-offs taken would not have to be fully recovered before such
loans are returned to accrual status. Loans that meet the above criteria would
continue to be disclosed as past due, as appropriate, until they have been
brought fully current.
The basic example of a TDR multiple note structure is a troubled loan that is
restructured into two notes where the first or "A" note represents the portion
of the original loan principal amount which is expected to be fully collected
along with contractual interest. The second part of the restructured loan, or
"B" note, represents the portion of the original loan that has been charged-off.
Such TDRs generally may take any of three forms. (1) In certain TDRs, the "B"
note may be a contingent receivable that is payable only if certain conditions
are met (e,g., sufficient cash flow from property). (2) For other TDRs, the "B"
note may be contingently forgiven (e.g., note "B" is forgiven if note "A" is
paid in full). (3) In other instances, an institution would have granted a
concession (e.g., rate reduction) to the troubled borrower but the "B" note
would remain a contractual obligation of the borrower. Because the "B" note is
not reflected as an asset on the institution's books and is unlikely to be
collected, for reporting purposes the "B" note could be viewed as a contingent
receivable.
Institutions may return the "A" note to accrual status provided the following
conditions are met:
Under existing reporting requirements, the "A" note would be disclosed as a
TDR. In accordance with these requirements, if the "A" note yields a market rate
of interest and performs in accordance with the restructured terms, such
disclosures could be eliminated in the year following restructuring. To be
considered a market rate of interest, the interest rate on the "A" note at the
time of restructuring must be equal to or greater than the rate that the
institution is willing to accept for a new receivable with comparable risk.
Sound consumer credit is based upon the borrower's willingness and ability to
pay as agreed. These ingredients are roughly measurable in terms of the
borrower's character and the amount and stability of income in relation to
current debt obligations. In turn, evidence of a consumer loan's soundness is
probably best indicated by the repayment performance demonstrated by the
borrower. These considerations, coupled with the fact that consumer loans are
typically small in size and large in number, mandate that a different approach
be utilized in appraising consumer credit than that which is generally followed
with respect to other loan categories. In any case, large lines and direct and
significant indirect dealer lines (not individual indirect paper) should receive
individual appraisal.
The FDIC has adopted a policy for classifying delinquent consumer instalment
loans held by commercial banks which utilizes a formula approach. This approach
parallels, in principle, current industry practices and recognizes the
statistical validity of measuring losses predicated on past-due status. The
policy covers both open and closed-end credit. Evaluating the quality of a
consumer credit portfolio on a loan-by-loan basis is inefficient and
unnecessary. For this reason, examiners are expected to adhere closely to the
policy in analyzing consumer credit. Nevertheless, it is recognized that there
are instances, particularly where significant amounts are involved, that may
warrant exceptions to the formula in order to recognize individual situations
where the bank being examined can clearly demonstrate that repayment will occur
irrespective of delinquency status. Examples of such situations might include
loans well-secured by collateral and in process of collection, loans where
claims have been filed against solvent estates and loans supported by valid
guarantees or insurance. Examiners will adhere to the following general
classification policy during examinations of commercial banks. Closed-end
consumer instalment credit delinquent 120 days or more (5 monthly payments) will
be classified Loss and loans delinquent 90 to 119 days (4 monthly payments) will
be classified Substandard. Open-end consumer instalment credit delinquent 180
days or more (7 zero billing cycles) will be classified Loss and loans
delinquent 90 to 179 days (4 to 6 zero billing cycles) will be classified
Substandard.
Under no circumstances should the formula approach be used for classification
of large business type loans serviced by instalment loan departments. The
following definitions are intended to provide guidance in application of the
policy.
Some banks consider a credit "cured" and no longer delinquent when a borrower
resumes monthly payments, even if delinquent principal is not repaid. This
practice is generally not objectionable provided the delinquency is not more
than 90 days, resumed payments have occurred for a minimum of 3 consecutive
months, another curing has not taken place within the preceeding 12 months, and
the loan balance does not exceed the predelinquency credit limit.
Use of the formula approach usually results in numerous items and, although
not to be included in the report, an itemized list is to be left with management
and the classified asset schedule should so indicate. A copy of the listing
should also be retained in the examiner's work papers.
Examiners are reminded that examiner support packages are available which
have built in parameters of the formula classification policy, and which
generate a listing of delinquent consumer loans to be classified in accordance
with the policy. Use of this package may expedite the examination in certain
cases, especially in larger banks.
Losses are one of the costs of doing business in consumer instalment credit
departments. It is important for the examiner to give consideration to the
amount of instalment loan charge-offs and the character thereof in examining the
department. Excessive loan losses are the product of weak lending and collection
policies and therefore provide a good indication of the soundness of the
consumer instalment loan operation. The examiner should be alert also to the
absence of instalment loan charge-offs, which may indicate that losses are being
deferred or covered up through unwarranted rewrites or extensions.
Dealer lines should be scheduled in the report under the dealer's name
regardless of whether the contracts are accepted with or without recourse. Any
classification or totaling of the nonrecourse line can be separately identified
from the direct or indirect liability of the dealer. Comments and format for
scheduling the indirect contracts will be essentially the same as for direct
paper. If there is direct debt, comments will necessarily have to be more
extensive and probably will help form a basis for the indirect classification.
No general rule can be established as to the proper application of dealers'
reserves to the examiner's classifications. Such a rule would be impractical
because of the many methods used by banks in setting up such reserves and the
various dealer agreements utilized. Generally, where the bank is handling a
dealer who is not financially responsible, weak contracts warrant classification
irrespective of any balance in the dealer's reserve. Fair and reasonable
judgment on the part of the examiner will determine application of dealer
reserves.
If the amount involved would have a material impact on capital, consumer
loans should be classified net of unearned income. Large business-type loans
placed in consumer instalment loan departments should receive individual
appraisal and, in all cases, the applicable unearned income discount should be
deducted when such loans are classified.
Troubled debt restructuring takes place when a bank grants a concession to a
debtor in financial difficulty. Statement of Financial Accounting Standards No.
15 (FASB 15), Accounting by Debtors and Creditors for Troubled Debt
Restructurings, sets forth generally accepted accounting principles for
restructurings. It is the FDIC's policy that restructurings be reflected in
examination reports in accordance with FASB 15. In addition, banks are expected
to follow these principles when filing Reports of Condition and Income.
FASB 15 divides troubled debt restructurings into two broad groups: (1) those
wherein the borrower transfers assets to the creditor to satisfy the claim,
which would include foreclosures; and (2) those in which the terms of a debtor's
obligation are modified, which may include reduction in the interest rate,
extension of the maturity date and at an interest rate that is less than the
current market rate for new obligations with similar risk, or forgiveness of
principal or interest. A third type of restructuring combines a receipt of
assets and a modification of terms.
To illustrate, assume a bank forecloses on a defaulted mortgage loan of
$100,000 and takes title to the property. If the fair value of the realty at the
time of foreclosure is $80,000, the $20,000 loss should be immediately
recognized by a charge to the allowance for loan and lease losses. If the bank
is on an accrual basis of accounting, there may also be adjusting entries
necessary to reduce both the accrued interest receivable and loan interest
income accounts. Assume further that in order to effect sale of the realty to a
third party, the bank is willing to offer a new mortgage loan (e.g., of
$100,000) at a concessionary rate of interest (e.g., 10% while the market rate
for new loans with similar risk is 20%). Before booking this new transaction,
the bank must establish its "economic value". Pursuant to Accounting Principles
Board Opinion No. 21 (APBO 21, Interest on Receivables and Payables), the value
is represented by the sum of the present value of the income stream to be
received from the new loan, discounted at the current market rate for this type
of credit, and the present value of the principal to be received, also
discounted at the current market rate. This economic value is the proper
carrying value for the asset at its origination date, and if less than the fair
value at time of foreclosure (e.g., $78,000 vs. $80,000), an additional loss has
been incurred and should be immediately recognized. This additional loss should
be reflected in the allowance if a relatively brief period has elapsed between
foreclosure and subsequent resale of the property. However, the loss should be
treated as "other operating expenses" if the asset has been held for a longer
period. The new loan would be placed on the books at its face value ($100,000)
and the difference between the new loan amount and the "economic value"
($78,000) is treated as unearned discount ($22,000). For examination and Report
of Condition purposes, the asset would be shown net of the unearned discount
which is reduced periodically as it is earned over the life of the new loan.
Interest income is earned on the restructured loan at the previously established
market rate. This is computed by multiplying the carrying value (i.e., face
amount of the loan reduced by any principal payments, less unearned discount) by
that rate (20%).
The basis for this accounting approach is the assumption that financing the
resale of the property at a concessionary rate exacts an opportunity cost which
the bank must recognize. That is, unearned discount represents the present value
of the "imputed" interest differential between the concessionary and market
rates of interest. Present value accounting also assumes that both the bank and
the third party who purchased the property are indifferent to a cash sales price
at the "economic value" or a higher financed price repayable over time.
If the terms are modified to the extent that total future cash receipts are
less than the outstanding principal balance plus accrued and unpaid interest
(plus or minus unamortized premium or discount), immediate loss recognition
under FASB 15 is required. This situation might arise if the bank forgives a
portion of principal or interest. The amount of loss is represented by the
difference between the total future payments under the modified terms and the
current balance of the present obligation. The initial balance at which the
asset would be carried on the bank's books would be equal to these total future
payments. Moreover, no interest income should be recognized over the life of
this restructured asset, instead, all payments are to be applied to the loan or
security balance.
Examination procedures for reviewing troubled debt restructuring is included
in the Examination Modules Handbook as a section under Loan References.
The Items Subject to Adverse Classification schedule allows an examiner to
present pertinent and readily understandable comments related to loans which are
adversely classified. In addition, the Analysis of Loans Subject to Adverse
Classification schedule permits analysis of present and previous classifications
from the standpoint of source and disposition. These loan schedules should be
prepared in accordance with the Report of Examination Instructions and current
memoranda.
An examiner must present in written form pertinent and readily understandable
comments related to loans which are subject to criticism. To accomplish this, a
thorough understanding of all factors surrounding the loan is required and only
those germane to its description, collectability and management plans should be
included in the comments. Comments should be brief and concise, but brevity is
not to be accomplished by omission of adequate and pertinent information.
Comments should be informative and factual data emphasized. The important
weaknesses of the loan should not be overshadowed by extraneous information
which might well have been omitted. An ineffective presentation of a classified
loan weakens the value of an examiner's report and frequently casts doubt on the
accuracy of the classifications. The essential test of loan comments is whether
they justify the classification.
Careful organization is an important ingredient of good loan comments.
Generally, loan comments should consist of the following elements:
Examiners should avoid arbitrary or "penalty" classifications, nor should
"conceded" or "agreed" be given as the principal reason for adverse
classifications. Management's opinions and ideas should not have to be
emphasized; if a classification is well-founded, the facts will speak for
themselves. If well- written, there is little need for long summary comments
reemphasizing major points of the loan write-up.
When the volume of loan classifications reaches the point of causing
supervisory concern, analysis of present and previous classifications from the
standpoint of source and disposition becomes very important. For this reason,
the Analysis of Loans Subject to Adverse Classification schedule should be
completed in the following cases: banks which examiners regard as possessing
characteristics which present special supervisory problems; when the volume or
composition of adversely classified loans has changed significantly since the
previous examination, including both upward and downward movements; and, in such
other special or unusual situations as examiners deem appropriate. Generally, it
is intended that the schedule not include consumer loans and overdrafts and it
should be footnoted to indicate that these assets are not included. This
schedule can be a very useful tool in developing the Examination Conclusions and
Comments for the report of examination.
To be eligible for this accounting method for tax purposes, an institution
must file a conformity election with its federal income tax return. The tax
regulations also require the institution's primary federal supervisory authority
to expressly determine that the institution maintains and applies loan loss
classification standards that are consistent with the regulatory standards of
its supervisory authority.
For taxable years ending before the completion of the first examination of an
institution's loan review process that is after October 1, 1992, transition
rules allow an institution to make the conformity election without the
determination letter from its primary supervisory authority. However, the letter
must be obtained at the first examination involving the loan review process
after October 1, 1992. If the letter is not issued by the supervisory authority
at the examination, the election is revoked retroactively.
Once the first examination of the loan review process after October 1, 1992,
has been performed by an institution's primary federal supervisory authority,
the transition rules no longer apply and the institution must have the "express
determination" letter before making the election. To continue using the tax-book
conformity method, the institution must request a new letter at each subsequent
examination that covers the loan review process. If the examiner does not issue
an "express determination" letter at the end of such an examination, the
institution's election of the tax-book conformity method is revoked
automatically as of the beginning of the taxable year that includes the date of
examination. However, that examiner's decision not to issue an "express
determination" letter does not invalidate an institution's election for any
prior years. The supervisory authority is not required to rescind any previously
issued "express determination" letters.
When an examiner does not issue an "express determination" letter, the
institution is still allowed tax deductions for loans that are wholly or
partially worthless. However, the burden of proof is placed on the institution
to support its tax deductions for loan charge-offs.
When requested by a bank that has made or intends to make the election under
Section 1.166-2(d)(3) of the tax regulations, the examiner-in-charge should
issue an "express determination" letter, provided the bank does maintain
and apply loan loss classification standards that are consistent with the FDIC's
regulatory standards. The letter should only be issued at the completion of a
safety and soundness examination at which the examiner-in-charge has concluded
that the issuance of the letter is appropriate.
An "express determination" letter should be issued to a bank only if:
Minor criticisms of the bank's loan review process as it relates to loan
charge-offs or immaterial individual deviations from the FDIC's standards should
not preclude the issuance of an "express determination" letter.
An "express determination" letter should not be issued if:
When the issuance of an "express determination" letter is appropriate, it
should be prepared on FDIC letterhead using the following format. The letter
should be signed and dated by the examiner-in-charge and provided to the bank
for its files. The letter is not part of the report of examination.
Express Determination Letter for IRS Regulation 1.166-2(d)(3)
"In connection with the most recent examination of [Name of Bank], by the
Federal deposit Insurance Corporation, as of [examination date], we reviewed the
institution's loan review process as it relates to loan charge-offs. Based on
our review, we concluded that the bank, as of that date, maintained and applied
loan loss classification standards that were consistent with regulatory
standards regarding loan charge-offs.
This statement is made on the basis of a review that was conducted in
accordance with our normal examination procedures and criteria. It does not in
any way limit or preclude any formal or informal supervisory action (including
enforcement actions) by this supervisory authority relating to the institution's
loan review process or the level at which it maintains its allowance for loan
and lease losses.
[signature]
Examiner-in-charge
[date signed]
When an "express determination" letter is issued to a bank, a copy of the
letter as well as documentation of the work performed by examiners in their
review of the bank's loan loss classification standards should be maintained in
the workpapers. A copy of the letter should also be forwarded to the Regional
Office with the report of examination. A comment indicating that an "express
determination" letter was provided to the bank should be included on page A of
the report of examination.
When an examiner-in-charge concludes that the conditions for issuing a
requested "express determination" letter have not been met, the
examiner-in-charge should discuss the reasons for this conclusion with the
Regional Office. The examiner-in-charge should then advise bank management that
the letter cannot be issued and explain the basis for this conclusion. A comment
indicating that a requested "express determination" letter could not be issued,
together with a brief statement of the reasons for not issuing the letter should
be included on page A of the report of examination.
Generally a concentration is a significantly large volume of
economically-related assets that an institution has advanced or committed to one
person, entity or affiliated group. These assets may in the aggregate present a
substantial risk to the safety and soundness of the institution. Adequate
diversification of risk allows the institution to avoid the excessive risks
imposed by credit concentrations. It should also be recognized, however, that
factors such as location and economic environment of the area limit some
institutions' ability to diversify. Where reasonable diversification
realistically cannot be achieved, the resultant concentration calls for capital
levels higher than the regulatory minimums.
Concentrations generally are not inherently bad, but do add a dimension of
risk which the management of the institution should consider when formulating
plans and policies. In formulating these policies, management should, at a
minimum, address goals for portfolio mix and limits within the loan and other
asset categories. The institution's business strategy, management expertise and
location should be considered when reviewing the policy. Management should also
consider the need to track and monitor the economic and financial condition of
specific geographic locations, industries and groups of borrowers in which the
bank has invested heavily. All concentrations should be monitored closely by
management and receive a more in-depth review than the diversified portions of
the institution's assets. To establish a meaningful tracking system for
concentrations of credit, financial institutions should be encouraged to
consider the use of codes to track individual borrowers, related groups of
borrowers, industries, and individual foreign countries. Financial institutions
should also be encouraged to use the standard industrial classification (SIC) or
similar code to track industry concentrations.
Refer to the Report of Examination Instructions for guidance in identifying
and listing concentrations in the examination report.
Federal funds sold and securities purchased under agreement for resale
represent convenient methods to employ excess funds to enhance earnings. Federal
funds are excess reserve balances and take the form of a one-day transfer of
funds between banks. These funds carry a specified rate of interest and are free
of the risk of loss due to fluctuations in market prices entailed in buying and
selling securities. However, these transactions are usually unsecured and
therefore do entail potential credit risk. Securities purchased under agreement
for resale represent an agreement between the buying and selling banks that
stipulates the selling bank will buy back the securities sold at an agreed price
at the expiration of a specified period of time.
Federal funds sold are not "risk free" as is often supposed, and the examiner
will need to recognize the elements of risk involved in such transactions. While
the selling of funds is on a one-day basis, these transactions may evolve into a
continuing situation. This development is usually the result of liability
management techniques whereby the buying bank attempts to utilize the acquired
funds to support a rapid expansion of its loan-investment posture and as a means
of enhancing profits. Of particular concern to the examiner is that, in many
cases, the selling bank will automatically conclude that the buying bank's
financial condition is above reproach without proper investigation and analysis.
If this becomes the case, the selling bank may be taking an unacceptable risk
unknowingly.
Another area of potential risk involves selling Federal funds to a bank which
may be acting as an intermediary between the selling bank and the ultimate
buying bank. In this instance, the intermediary bank is acting as agent with the
true liability for repayment accruing to the third bank. Therefore, it is
particularly important that the original selling bank be aware of this
situation, ascertain the ultimate disposition of its funds, and be satisfied as
to the creditworthiness of the ultimate buyer of the funds.
Clearly, the "risk free" philosophy regarding the sale of Federal funds is
inappropriate. Selling banks must take the necessary steps to assure protection
of their position. The examiner is charged with the responsibility of
ascertaining that selling banks have implemented and adhered to policy
directives in this regard to forestall any potentially hazardous situations.
Examiners should encourage management of banks engaged in selling Federal
funds to implement a policy with respect to such activity. This policy should
include consideration of such matters as the aggregate sum to be sold at any one
time, the maximum amount to be sold to any one buyer, the maximum duration of
time the bank will sell to any one buyer, a list of acceptable buyers, and the
terms under which a sale will be made. As in any form of lending, thorough
credit evaluation of the prospective purchaser, both before granting the credit
extension and on a continuing basis, is a necessity. Such credit analysis should
emphasize the borrower's ability to repay, the source of repayment, and
alternative sources of repayment should the primary source fail to materialize.
While sales of Federal funds are normally unsecured unless otherwise regulated
by State statutes, and while collateral protection is no substitute for thorough
credit review, the selling bank should consider the possibility of requiring
security if sales agreements are entered into on a continuing basis for specific
but extended periods of time, or for overnight transactions which have evolved
into longer term sales. Where the decision is made to sell Federal funds on an
unsecured basis, the selling bank should be able to present logical reasons for
such action based on conclusions drawn from its credit analysis of the buyer and
bearing in mind the potential risk involved.
A review of Federal funds sold between examinations may prompt examiners to
broaden the scope of their analysis of such activity if the transactions are not
being handled in accordance with sound practices as outlined above. Where the
bank has not developed a formal policy regarding the sale of Federal funds or
fails to conduct a credit analysis of the buyer prior to a sale and during a
continuous sale of such funds, the matter should be discussed with management.
In such discussion, it is incumbent upon examiners to inform management that
their remarks are not intended to cast doubt upon the financial strength of any
bank to whom Federal funds are sold. Rather, the intent is to advise the banker
of the potential risks of such practices unless safeguards are developed. The
need for policy formulation and credit review on all Federal funds sold should
be reinforced via a comment on the Administration, Supervision, and Control
schedule. Also, if Federal funds sold to any one buyer equals or exceeds 100% of
the selling bank's Tier 1 Capital, it should be listed on the Concentrations
schedule unless secured by U.S. Government securities. Based on the
circumstances, the examiner should determine the appropriateness of additional
comments regarding risk diversification.
Securities purchased under an agreement to resell are generally purchased at
prevailing market rates of interest. The purchasing bank must keep in mind that
the transaction merely represents another form of lending. Therefore,
considerations normally associated with granting secured credit should be made.
Repayment or repurchases by the selling bank is a major consideration, and the
buying bank should satisfy itself that the selling bank will be able to generate
the necessary funds to repurchase the securities on the prescribed date. Policy
guidelines should limit the amount of money extended to one seller. Collateral
coverage arrangements should be controlled by procedures similar to the
safeguards used to control any type of liquid collateral. Securities held under
such an arrangement should not be included in the bank's investment portfolio
but should be reflected in the report of examination under the caption
"Securities Purchased Under Agreements to Resell". Transactions of this nature
do not require entries to the securities account of either bank with the selling
bank continuing to collect all interest and transmit such payments to the buying
bank.
Laws and regulations that apply to credit extended by banks are more
complicated and continually in a state of change. However, certain fundamental
legal principles apply no matter how complex or innovative a lending
transaction. To avoid needless litigation and ensure that each loan is a legally
enforceable claim against the borrower or collateral, adherence to certain rules
and prudent practices relating to loan transactions and documentation is
essential. An important objective of the examiner's analysis of collateral and
credit files is not only to obtain information about the loan, but also to
determine if proper documentation procedures and practices are being utilized.
While examiners are not expected to be experts on legal matters, it is important
they be familiar with the Uniform Commercial Code (UCC) adopted by their
respective states as well as other applicable State laws governing credit
transactions. A good working knowledge of the various documents necessary to
attain the desired collateral or secured position, and how those documents are
to be used or handled in the jurisdiction relevant to the bank under
examination, is also essential.
With adoption of the UCC in all states except Louisiana, the legal
requirements of secured loan transactions have been substantially simplified and
standardized under Article 9 of the UCC. Examiners should note that the
following types of transaction are not covered by Article 9: security interest
subject to any statute of the United States such as the Ship Mortgage Act;
landlord's lien; lien given by statute or other rule of law for services or
materials; transfer of a claim for wages, salary or other compensation of an
employee; an equipment trust covering railway rolling stock; transfer of an
interest or claim in or under any policy of insurance; a right represented by a
judgment; sale of accounts or chattel paper when part of the sale of a business;
any right of setoff; an interest in or lien of real estate; and a transfer in
whole or in part of any deposit, savings passbook or like account.
In a secured transaction, the debtor assigns certain rights in specified
property. This interest provides the creditor with security. That is, if the
debt is not repaid, the creditor usually has the right to apply the proceeds
from the sale of the property, or collateral, toward payment of the debt. In an
unsecured transaction, the creditor has no interest in specific property of the
debtor, but does have a general interest in all the debtor's property.
Three terms basic to secured transactions are attachment, security agreement
and security interest. Attachment refers to that point when the creditor's legal
rights in the debtor's property come into existence or "attach". This does not
mean the creditor necessarily takes physical possession of the property, nor
does it mean acquisition of ownership of the property. Rather, it means that
before attachment, the borrower's property is free of any legal encumbrance, but
after attachment, the property is legally bound by the creditor's security
interest. In order for the creditor's security interest to attach, there must be
a security agreement in which the debtor assigns the specified property to the
creditor as security for the loan. A creditor's security interest can be
possessory or nonpossessory, purchase money or nonpurchase money. A creditor
with a possessory security interest takes physical possession of the collateral
until the debt is repaid. The general rule is a bank must take possession of
stocks and bonds to perfect a security interest therein. In a transaction
involving a nonpossessory security interest, the debtor retains possession of
the collateral. As the terms suggest, a creditor who provides funds so that the
borrower may purchase the collateral may obtain a purchase money security
interest in that collateral. Where the credit was not advanced to enable the
debtor to obtain the collateral, the security interest may be described as
nonpurchase money.
Examiners should determine bank policy concerning the checking of lien
positions prior to advancing funds. Failure to perform this simple procedure may
result in the bank unknowingly assuming a junior lien position and, thereby,
greater potential loss exposure. Filing records may be checked by management
personally or a lien search may be performed by the filing authority or other
responsible party. This is especially important when new credit lines are
granted by the bank.
The FDIC recognizes that liens do not have to be filed to create a legal
security interest in collateral. Nevertheless, banks are encouraged to take
every practicable measure to perfect their security interests as a normal
prudent lending practice. This is true regardless of the type of collateral
involved.
For farm products, additional costs are required to achieve lien perfection
against all parties. Whether or not this extra cost should be incurred is a
decision for bank management based on their perception of the value or
importance of the incremental protection obtained.
The FDIC expects bankers, as a matter of normal prudence, to take reasonable
precaution to protect their security interests in farm products even though
absolute protection may not be practical. Traditional UCC filings should be
recorded, and, if the state has established a central filing system, the bank's
security interest should be recorded there as well. In most instances, when
there is no central filing system, notification should be provided to the normal
local buyers of whatever farm product is involved and those prospective buyers
indicated by the borrower. Bank procedures should also include some periodic
verification that the collateral is still in the borrower's possession and in
acceptable condition. Also, deteriorating conditions or circumstances of a
borrower may dictate buyer notification even though it was not considered
necessary at origination of the loan.
In reviewing loans secured by farm products, examiners will consider a loan
secured (as opposed to unsecured) if the bank has established a legal security
interest in the collateral. Perfection of a lien always enhances the level of
protection provided by the bank's lien. The importance of lien perfection to an
examiner's assessment of the risk in any individual loan is a matter of
judgment, influenced by all the other circumstances and facts surrounding the
credit.
Under the UCC procedure for foreclosing security interests, four concepts are
involved. First is repossession or taking physical possession of the collateral,
which may be accomplished with judicial process or without judicial process
(known as self-help repossession), so long as no breach of the peace is
committed by the creditor. The former is usually initiated by a replevin action
in which the sheriff seizes the collateral under court order. A second important
concept of UCC foreclosure procedures is redemption or the debtor's right to
redeem the security after it has been repossessed. Generally, the borrower must
pay the entire balance of the debt plus all expenses incurred by the bank in
repossessing and holding the collateral. The third concept is retention which
allows the bank to retain the collateral in return for releasing the debtor from
all further liability on the loan. The borrower must agree to this action, hence
would likely be so motivated only when the value of the security is likely to be
less than or about equal to the outstanding debt. Finally, if retention is not
agreeable to both borrower and lender, the fourth concept, resale of the
security, comes into play. Although sale of the collateral may be public or
private, notice to the debtor and other secured parties must generally be given.
The sale must be commercially reasonable in all respects. Debtors are entitled
to any surplus resulting from sale price of the collateral less any unpaid debt.
If a deficiency occurs (i.e., the proceeds from sale of the collateral were
inadequate to fully extinguish the debt obligation), the bank has the right to
sue the borrower for this shortfall. This is a right it does not have under the
retention concept.
The second exception to the rule of priority concerns the vulnerability of
security interests perfected by doing nothing. While these interests are
perfected automatically, with the date of perfection being the date of
attachment, they are extremely vulnerable at the hands of subsequent bona fide
purchasers. Suppose, for example, a dealer sells a television set on a secured
basis to an ultimate consumer. Since the collateral is consumer goods, the
security interest is perfected the moment if attaches. But if the original buyer
sells the television set to another person who buys it in good faith and in
ignorance of the outstanding security interest, the UCC provides that the
subsequent purchase cuts off the dealer's security interest. This second
exception is much the same as the first except for one important difference: the
dealer (creditor) in this case can be protected against purchase of a customer's
collateral by filing a financing statement with the appropriate public official.
The third exception regards the after-acquired property clause which protects
the value of the collateral in which the creditor has a perfected security
interest. The after-acquired property clause ordinarily gives the original
creditor senior priority over creditors with later perfected interests. However,
it is waived as regards the creditor who supplies replacements or additions to
the collateral or the artisan who supplies materials and services which enhance
the value of the collateral as long as a perfected security interest in the
replacement or additions, or collateral is held.
Borrowing authorizations in essence permit one party to incur liability for
another. In the context of lending, this usually concerns corporations. A
corporation may enter into contracts within the scope of the powers authorized
by its charter. In order to make binding contracts on behalf of the corporation,
the officers must be authorized to do so either by the board of directors or by
expressed or implied general powers. Usually a special resolution expressly
gives certain officers the right to obligate the corporate entity, pledge assets
as collateral, agree to other terms of the indebtedness and sign all necessary
documentation on behalf of the corporate entity.
Although a general resolution is perhaps satisfactory for the short-term,
unsecured borrowings of a corporation, a specific resolution of the
corporation's board of directors is generally advisable to authorize such
transactions as term loans, loans secured by security interests in the
corporation's personal property, or mortgages on real estate. Further,
mortgaging or pledging substantially all of the corporation's assets without
prior approval of the shareholders of the corporation is often prohibited,
therefore, a bank may need to seek advice of counsel to determine if shareholder
consent is required for certain contemplated transactions.
Loans to corporations should indicate on their face that the corporation is
the borrower. The corporate name should appear followed by the name, title and
signature of the appropriate officer. If the writing is a negotiable instrument,
the UCC states the party signing is personally liable as a general rule. To
enforce payment against a corporation, the note or other writing should clearly
show that the debtor is a corporation.
Because of restrictions on the amount of credit a bank may extend to any one
borrower, there has developed the practice of a bank selling or participating
part of its loan to another bank in order to satisfy the credit needs of the
borrower. This is called a "participation" and there are a number of ways it may
occur. The customary method is that the borrower signs a note at the lead bank
which then sells an interest in the note to one or more banks pursuant to the
terms of a participation agreement. The agreement should spell out in detail all
terms, conditions and understandings between the lead bank and the
participant(s). The participation agreement ordinarily establishes which party
is paid first, what happens in the event of default, how setoffs received by
either bank are to be treated, how various expenses are to be divided, and who
is responsible to collect the note in the event of default. At the time a lead
bank sells an interest in the loan, it must fully disclose to the participating
bank information in its possession concerning the borrower. If not, it may be
liable to the participating bank for any loss suffered by the latter in the
event of default.
As mentioned previously, a bank generally obtains a security interest in
stocks and bonds by possession. The documents which allow the bank to sell the
securities if the borrower defaults are called stock powers and bond powers. The
examiner should ensure the bank has, for each borrower who has pledged stocks or
bonds, one signed stock power for all stock certificates of a single issuer, and
a separate signed bond power for each bond instrument. The signature must agree
with the name on the actual stock certificate or bond instrument.
Two or more persons who are parties to a contract or promise to pay are known
as comakers. They are a unit to the performance of one act and are considered
primarily liable. In the case of default on an unsecured loan, a judgment would
be obtained against all. A release against one is a release against all because
there is but one obligation and if that obligation is released as to one
obligor, it is released as to all others.
Since banks often condition credit advances upon the backup support provided
by third party guarantees, examiners should understand the legal fundamentals
governing guarantees. A guarantee may be a guarantee of payment or of
collection. "Payment guaranteed" or equivalent words added to a signature means
that if the instrument is not paid when due, the guarantor will pay it according
to its terms without resort by the holder to any other party. "Collection
guaranteed" or equivalent words added to a signature means that if the
instrument is not paid when due, the guarantor will pay it, but only after the
holder has reduced to judgment a claim against the maker and execution has been
returned unsatisfied, or after the maker has become insolvent or it is otherwise
useless to proceed against such a party.
Contracts of guarantee are further divided into a limited guarantee which
relates to a specific note (often referred to as an "endorsement") or for a
fixed period of time, or a continuing guarantee which, in contrast, is
represented by a separate instrument and enforceable for future (duration
depends upon State law) transactions between the bank and the borrower or until
revoked. A well drawn continuing guarantee contains language substantially
similar to the following: "This is an absolute and unconditional guarantee of
payment, is unconditionally delivered, and is not subject to the procurement of
a guarantee from any person other than the undersigned, or to the performance or
happening of any other condition." The aforementioned unambiguous terms are
necessary to the enforceability of contracts of guarantee, as they are
frequently entered into solely as an accommodation for the borrower and without
the guarantor's participation in the benefits of the loan. Thus, courts tend to
construe contracts of guarantee strictly against the party claiming under the
contract. Unless the guarantee is given prior to or at the time the initial loan
is made, the guarantee may not be enforceable because of the difficulty of
establishing that consideration was given. Banks should not disburse funds on
such loans until they have the executed guarantee agreement in their possession.
Banks should also require the guarantee be signed in the presence of the loan
officer, or, alternatively, that the guarantor's signature be notarized. If the
proposed guarantor is a partnership, joint venture, or corporation, the examiner
should ensure the signing party has the legal authority to enter into the
guarantee agreement. Whenever there is a question concerning a corporation's
authority to guarantee a loan, counsel should be consulted and a special
corporate resolution passed by the organization's board of directors.
A bank extending credit to a closely held corporation may want to have the
company's officers and shareholders subordinate to the bank's loan any
indebtedness owed them by the corporation. This is accomplished by execution of
a subordination agreement by the officers and shareholders. Subordination
agreements are also commonly referred to as standby agreements. Their basic
purpose is to prevent diversion of funds from reduction of bank debt to
reduction of advances made by the firm's owners or officers.
This is an agreement whereby the owner of property grants a security interest
in collateral to the bank to secure the indebtedness of a third party. Banks
often take possession of the stock certificates, plus stock powers endorsed in
blank, in lieu of a hypothecation agreement. Caution, however, dictates that the
bank take a hypothecation agreement setting forth the bank's rights in the event
of default.
A mortgage may be defined as a conveyance of realty given with the intention
of providing security for the payment of debt. There are several different types
of mortgage instruments but those commonly encountered are regular mortgages,
deeds of trust, equitable mortgages, and deeds absolute given as security.
The examiner should ensure the bank has performed a title and lien search of
the property prior to taking a mortgage or advancing funds. Proper procedure
calls for an abstractor bringing the abstract up to date, and review of the
abstract by an attorney or title insurance company. If an attorney performs the
task, the abstract will be examined and an opinion prepared indicating in whom
title rests, along with any defects and encumbrances disclosed by the abstract.
Like an abstractor, an attorney is liable only for damages occasioned by
negligence. If a title insurance company performs the task of reviewing the
abstract, it does essentially the same thing, however, when title insurance is
obtained, it represents a contract to make good, loss arising through defects in
title to real estate or liens or encumbrances thereon. Title insurance covers
various items not covered in an abstract and title opinion. Some of the more
common are errors by abstractors or attorneys, unauthorized corporate action,
mistaken legal interpretations, and unintentional errors in public records by
public officials. Once the bank determines title and lien status of the
property, the mortgage can be prepared and funds advanced. The bank should
record the mortgage immediately after closing the loan. Form, execution, and
recording of mortgages varies from state to state and therefore must conform to
the requirements of State law.
An assignment is generally considered as the transfer of a legal right from
one person to another. The rights acquired under a contract may be assigned if
they relate to money or property, but personal services may not be assigned.
Collateral assignments are used to establish the bank's rights as lender in the
property or asset serving as collateral. It is generally used for loans secured
by savings deposits, certificates of deposit or other cash accounts as well as
loans backed by cash surrender value of life insurance. In some instances, it is
used in financing accounts receivable and contracts. If a third party holder of
the collateral is involved, such as life insurance company or the payor of an
assigned contract, an acknowledgement should be obtained from that party as to
the bank's assigned interest in the asset for collateral purposes.
Familiarity with the basic terms and concepts of the Federal bankruptcy law
(formally known as the Bankruptcy Reform Act of 1978) is necessary in order for
examiners to make informed judgments concerning the likelihood of collection of
loans to bankrupt individuals or organizations. It must be stressed the
following paragraphs present only an overview of the subject. Complex situations
may arise where more in-depth consideration of the bankruptcy provisions may be
necessary and warrant consultation with the bank's attorney, Regional Counsel or
other member of the Regional Office staff. For the most part, however, knowledge
of the following information when coupled with review of credit file data and
discussion with bank management should enable examiners to reach sound
conclusions as to the eventual repayment of the bank's loans.
Liquidation and rehabilitation are the two basic types of bankruptcy
proceedings. Liquidation is pursued under Chapter 7 of the law and involves the
bankruptcy trustee collecting all of the debtor's nonexempt property, converting
it into cash and distributing the proceeds among the debtor's creditors. In
return, the debtor obtains a discharge of all debts outstanding at the time the
petition was filed which releases the debtor from all liability for those
pre-bankruptcy debts.
Rehabilitation (sometimes known as reorganization) is effected through
Chapter 11 or Chapter 13 of the law and in essence provides that creditors'
claims are satisfied not via liquidation of the obligor's assets but rather from
future earnings. That is, debtors are allowed to retain their assets but their
obligations are restructured and a plan is implemented whereby creditors may be
paid.
Chapter 11 bankruptcy is available to all debtors, whether individuals,
corporations or partnerships. Chapter 13 (sometimes referred to as the "wage
earner plan"), on the other hand, may be used only by individuals with regular
incomes and when their unsecured debts are under $100,000 and secured debts less
than $350,000. The aforementioned rehabilitation plan is essentially a contract
between the debtor and the creditors. Before the plan may be confirmed, the
bankruptcy court must find it has been proposed in good faith and that creditors
will receive an amount at least equal to what would be received in a Chapter 7
proceeding. In a Chapter 11 reorganization, all creditors are entitled to vote
on whether or not to accept the repayment plan. In Chapter 13 proceedings, only
secured creditors are so entitled. A majority vote binds the minority to the
plan, provided the latter will receive pursuant to the plan at least the amount
they would have received in a straight liquidation. The plan is fashioned so
that it may be carried out in three years although the court may extend this to
five years.
Most cases in bankruptcy courts are Chapter 7 proceedings, but reorganization
cases are increasingly common. From the creditor's point of view, Chapter 11 or
13 filings generally result in greater debt recovery than do liquidation
situations under Chapter 7. Nonetheless, the fact that reorganization plans are
tailored to the facts and circumstances applicable to each bankrupt situation
means that they vary considerably and the amount recovered by the creditor may
similarly vary from nominal to virtually complete recovery.
Trustees are selected by the borrower's creditors and are responsible for
administering the affairs of the bankrupt debtor's estate. The bankrupt's
property may be viewed as a trust for the benefit of the creditors, consequently
it follows the latter should, through their elected representatives, exercise
substantial control over this property.
When a debtor files a bankruptcy petition with the court, the case is
described as a voluntary one. It is not necessary the individual or organization
be insolvent in order to file a voluntary case. Creditors may also file a
petition, in which case the proceeding is know as an involuntary bankruptcy.
However, this alternative applies only to Chapter 7 cases and the debtor
generally must be insolvent, i.e., unable to pay debts as they mature, in order
for an involuntary bankruptcy to be filed.
Filing of the bankruptcy petition requires (with limited exceptions)
creditors to stop or "stay" further action to collect their claims or enforce
their liens or judgements. Actions to accelerate, set off or otherwise collect
the debt are prohibited once the petition is filed, as are post- bankruptcy
contacts with the obligor (such as "dunning" letters). The stay remains in
effect until the debtor's property is released from the estate, the bankruptcy
case is dismissed, the debtor obtains or is denied a discharge, or the
bankruptcy court approves a creditor's request for termination of the stay. Two
of the more important grounds applicable to secured creditors under which they
may request termination are as follows: (1) The debtor has no equity in the
encumbered property, and the property is not necessary to an effective
rehabilitation plan; or (2) The creditor's interest in the secured property is
not adequately protected. In the latter case, the law provides three methods by
which the creditor's interests may be adequately protected: the creditor may
receive periodic payments equal to the decrease in value of the creditor's
interest in the collateral; or an additional or substitute lien on other
property may be obtained; or some other protection is arranged (e.g., a
guarantee by a third party) to adequately safeguard the creditor's interests. If
these alternatives result in the secured creditor being adequately protected,
relief from the automatic stay will not be granted. If relief from the stay is
obtained, creditors may continue to press their claims upon the bankrupt's
property free from interference by the debtor or the bankruptcy court.
When a borrower files a bankruptcy petition, an "estate" is created and,
under Chapter 7 of the law, the property of the estate is passed to the trustee
for distribution to the creditors. Certain of the debtor's property is exempt
from distribution under all provisions of the law (not just Chapter 7), as
follows: homeowner's equity up to $7,500; automobile equity and household items
up to $1,200; jewelry up to $500; cash surrender value of life insurance up to
$4,000; Social Security benefits (unlimited); and miscellaneous items up to $400
plus any unused portion of the homeowner's equity. The bankruptcy code
recognizes a greater amount of exemptions may be available under State law and,
if State law is silent or unless it provides to the contrary, the debtor is
given the option of electing either the Federal or State exemptions. Examiners
should note that some liens on exempt property which would otherwise be
enforceable are rendered unenforceable by the bankruptcy. A secured lender may
thus become unsecured with respect to the exempt property. The basic rule in
these situations is that the debtor can render unenforceable judicial liens on
any exempt property and security interests that are both nonpurchase money and
nonpossessory on certain household goods, tools of the trade and health aids.
The discharge, as mentioned previously, protects the debtor from further
liability on the debts discharged. Sometimes, however, a debtor is not
discharged at all (i.e., the creditor has successfully obtained an "objection to
discharge") or is discharged only as regards a specific creditor(s) and a
specific debt(s) (an action known as "exception to discharge"). The borrower
obviously remains liable for all obligations not discharged, and creditors may
pursue customary collection procedures with respect thereto. Grounds for an
"objection to discharge" include the following actions or inactions by the
bankrupt debtor (this is not an all-inclusive list): fraudulent conveyance
within 12 months of filing the petition; unjustifiable failure to keep or
preserve financial records; false oath or account or presentation of a false
claim in the bankruptcy case and estate, respectively; withholding of books or
records from the trustee; failure to satisfactorily explain any loss or
deficiency of assets; refusal to testify when legally required to do so; and
receiving a discharge in bankruptcy within the last six full years. Some of the
bases upon which creditors may file "exceptions to discharge" are: nonpayment of
income taxes for the three years preceding the bankruptcy; money, property or
services obtained through fraud, false pretenses or false representation; debts
not scheduled on the bankruptcy petition and which the creditor had no notice;
alimony or child support payments (this exception may be asserted only by the
debtor's spouse or children, property settlements are dischargeable); and
submission of false or incomplete financial statements. If a bank attempts to
seek an exception on the basis of false financial information, it must prove the
written financial statement was materially false, it reasonably relied on the
statement, and the debtor intended to deceive the bank. These assertions can be
difficult to prove. Discharges are unavailable to corporations or partnerships.
Therefore, after a bankruptcy, corporations and partnerships often dissolve or
become defunct.
Debtors sometimes promise their creditors after a bankruptcy discharge that
they will repay a discharged debt. An example wherein a debtor may be so
motivated involves the home mortgage. To keep the home and discourage the
mortgagee from foreclosing, a debtor may reaffirm this obligation. This process
of reaffirmation is an agreement enforceable through the judicial system. The
law sets forth these basic limitations on reaffirmations: the agreement must be
signed before the discharge is granted; a hearing is held and the bankruptcy
judge informs the borrower there is no requirement to reaffirm; and the debtor
has the right to rescind the reaffirmation if such action is taken within 30
days.
The first class of creditors is known as priority creditors. As the name
implies, these creditors are entitled to receive payment prior to any others.
Priority payments include administrative expenses of the debtor's estate,
unsecured claims for wages and salaries up to $2,000 per person, unsecured
claims for employee benefit plans, unsecured claims of individuals up to $900
each for deposits in conjunction with rental or lease of property, unsecured
claims of governmental units and certain tax liabilities. Secured creditors are
only secured up to the extent of the value of their collateral. They become
unsecured in the amount by which collateral is insufficient to satisfy the
claim. Unsecured creditors are of course the last class in terms of priority.
An important objective of the Bankruptcy Reform Act of 1978 is to achieve
equality of distribution among classes of creditors. Consequently, certain
actions taken by a creditor before or during bankruptcy proceedings may be
invalidated by the trustee if they result in certain creditors receiving more
than their share of the debtor's estate. These actions are called "transfers"
and fall into two categories. The first involves absolute transfers, such as
payments received by a creditor; the trustee may invalidate this action and
require the payment be returned and made the property of the bankrupt estate. A
transfer of security, such as the granting of a mortgage, may also be
invalidated by the trustee. Hence, the trustee may require previously encumbered
property be made unencumbered, in which case the secured party becomes an
unsecured creditor. This has obvious implications as regards loan
collectability.
Preferences are a potentially troublesome area for banks and examiners should
have an understanding of basic principles applicable to them. Some of the more
important of these are listed here. (1) A preference may be invalidated (also
known as "avoided") if it has all of these elements: the transfer was to or for
the benefit of a creditor; the transfer was made for or on account of a debt
already outstanding; the transfer has the effect of increasing the amount a
creditor would receive in Chapter 7 proceedings; the transfer was made within 90
days of the bankruptcy filing, or within one year if the transfer was to an
insider who had reasonable cause to believe the debtor was insolvent at the time
of transfer; and the debtor was insolvent at the time of the transfer. Under
bankruptcy law, borrowers are presumed insolvent for 90 days prior to filing the
bankruptcy petition. (2) Payment to a fully secured creditor is not a preference
because such a transfer would not have the effect of increasing the amount the
creditor would otherwise receive in a Chapter 7 proceeding. Payment to a
partially secured creditor does, however, have the effect of increasing the
creditor's share and is thus deemed a preference which the trustee may avoid.
(3) Preference rules also apply to a transfer of a lien to secure past debts, if
the transfer has all five elements set forth under (1). (4) There are certain
situations wherein a debtor has given a preference to a creditor but the trustee
is not permitted to invalidate it. A common example concerns floating liens on
inventory under the Uniform Commercial Code. These matters are subject to
complex rules, however, and consultation with the Regional Office may be
advisable when this issue arises.
Setoffs occur when a party is both a creditor and a debtor of another;
amounts which a party owes are netted against amounts which are owed to that
party. If a bank exercises its right of setoff properly and before the
bankruptcy filing, the action is generally upheld in the bankruptcy proceedings.
Setoffs made after the bankruptcy may also be valid but certain requirements
must be met of which the following are especially important: First, the debts
must be between the same parties in the same right and capacity. For example, it
would be improper for the bank to set off the debtor's loan against a checking
account of the estate of the obligor's father, of which the debtor is executor.
Second, both the debt and the deposit must precede the bankruptcy petition
filing. Third, the setoff may be disallowed if funds were deposited in the bank
within 90 days of the bankruptcy filing and for the purpose of creating or
increasing the amount to be set off.
Under most circumstances, a bank which has not recorded its mortgage or
otherwise fails to perfect its security interest in a proper timely manner, runs
great risk of losing its security. This is a complex area of the law but
prudence clearly dictates that liens be properly obtained and timely filed so
that the possibility of losing the protection provided by collateral is
eliminated.
Qualifications of Loan Review Personnel
Independence of Loan Review Personnel
Frequency of Reviews
Scope of Reviews
Depth of Reviews
Review of Findings and Follow-up
Workpaper and Report Distribution
Allowance For Loan And Lease Losses (ALLL)
Responsibility Of The Board And Management
Factors To Consider In Estimating Credit Losses
Regulatory Reporting Of The ALLL
Accounting And Reporting Treatment
Portfolio Composition
Commercial Loans
Highly Leveraged Transaction (HLTs)
General Policy Statement
If a bank intends to engage in HLT
financing, examiners should determine whether the bank's board of directors has
adopted a written policy statement that clearly defines a HLT, as well as the
bank's overall philosophy and objectives in financing HLTs. The policy should
include:
Portfolio Analysis And Management Information System (MIS)
Examiners should determine whether a separate, specific MIS and
analysis process has been established as part of the overall management and
control of HLT financing. The process should be sufficiently detailed to provide
management and the board with periodic information on the overall size, quality
and performance of the HLT portfolio.
Distribution And Participations
Asset sales, participations,
syndication and other means of distribution are critical elements in the rapid
growth of HLT financing. Many banks have a stated goal of creating assets and
redistributing them to limit their risks by diversifying their portfolios. Both
the lead and purchasing banks are expected to adopt formal policies and
procedures on sales and distribution of participations in HLT financing.
Management and the board should be familiar with applicable regulatory
guidelines governing asset participations, purchases and sales, and should
ensure full compliance with those guidelines.
Internal Reviews
Independent assessments of the HLT portfolio are an
important part of an institution's overall control and MIS process. The unique
characteristics and risks of these loans make early detection of emerging trends
and potential problems essential. Examiners should assess the nature and extent
of the bank's HLT review and control process. At a minimum, the process should
provide for an annual review of all HLT credits as a separate portfolio. This
process should supplement the bank's normal management review process for the
loan portfolio. The review should include:
Equity Investments
A number of banking organizations, primarily but
not exclusively the multi-national banking companies, have direct and/or
indirect equity investments in HLTs. Intense competition for business has led
banking companies to provide or arrange financing for all aspects of a proposed
transaction, including equity positions. Equity investments have been made by
Small Business Investment Corporations owned by banks, bank holding companies
and their affiliates. Indirect investments have been acquired through investment
in specialized funds (LBO funds) whose sole purpose is to provide financing for
HLTs for their own accounts. Banks generally have not made direct equity
investments or investments in LBO funds. Equity investments generally involve
higher levels of risk than either senior or junior debt and where permitted
should be governed by adequate policies, procedures, controls and MIS. At a
minimum, policies should establish an approval and review process for such
activities.
Mezzanine Financing
Mezzanine financing represents those parts of
an HLT's financing package that are neither equity nor senior debt. It usually
is extended through subsidiaries of banks or nonbank subsidiaries of bank
holding companies. Examiners should review policies for mezzanine financing to
ensure that they generally include:
Allowance For Loan And Lease Losses
The potential impact of a
bank's participation in financing HLTs should be carefully considered when
reviewing the adequacy of the allowance for loan and lease losses (ALLL). The
aggregate size and overall condition of the HLT portfolio should be specifically
addressed in any review of the overall adequacy of the allowance. Examiners
should review the bank's methodology for incorporating the special risks related
to HLT financing in its determination of the adequacy of ALLL. Management's
internal risk rating system is expected to include assessment of its equity and
mezzanine financing portfolio in determining the need for valuation reserves.
Legal Reviews And Potential Conflicts Of Interest
Examiners should
determine whether a bank's board of directors and management have established
policies on HLTs to minimize risks posed by potential legal and
conflict-of-interest issues. Policies should provide for legal review of all
bank involvement with HLTs to determine that they are permissible for banking
organizations and to address potential conflicts of interest. Several examples
illustrate this point:
Conflicts Of Interest
Conflicts of interest may arise when a
banking company is involved in financing a transaction and takes an equity
interest in the transaction. When a banking company plays multiple roles in
connection with an HLT, the interests of different customers, or the interests
of the bank and its customers, may conflict.
Equitable Subordination
If a bank as senior lender exercises some
measures of management control, a court could rank the bank's interest on a par
with those of junior creditors. A bank may be more vulnerable to this risk if
its holding company is also participating in the mezzanine and/or equity
financing of an HLT.
Securities Laws
Equity interests and certain debt instruments used
in HLTs may constitute "securities" for purposes of federal laws. When
securities are involved, bank's should ensure compliance with applicable
securities law requirements, including disclosure and regulatory requirements.
Banks should also establish procedures to restrict the internal dissemination of
material nonpublic information about an HLT to persons who are involved in the
transaction.
Evaluating Individual Credits
In evaluating individual loans and
credit files, particular attention should be addressed to: 1) the overall
performance and profitability of the industry over time, including during
periods of economic or financial adversity; 2) the history and stability of the
borrower's market share, earnings and cash flow, particularly over the most
recent business cycle and the last economic downturn; 3) the reasonableness of
earnings and cash flow projections; 4) the relationship between the borrowing
company's projected cash flow and debt service requirements and the resulting
margin of debt service coverage; and 5) the reliability and stability of
collateral scenarios, and the adequacy of collateral coverage.
Oil And/or Gas Reserve-based Loans
However, for any such loan with an LTV ratio that equals or
exceeds 90 percent at origination, an institution should require appropriate
credit enhancement in the form of either mortgage insurance or readily
marketable collateral.
Examination Guidelines
Institutions should develop policies that
are clear, concise, consistent with sound real estate lending practices, and
meet their needs. Policies should not be so complex that they place excessive
paperwork burden on the institution. Therefore, when evaluating compliance with
Part 365, examiners should carefully consider the following:
Real Estate Construction Loans
Agricultural Loans
Introduction
Agricultural Loan Types And Maturities
Financial And Other Credit Information
As with any type of lending,
sufficient information must be available so that the bank can make informed
credit decisions. Basic information includes balance sheets, income statements,
cash flow projections, loan officer file comments, and collateral inspections,
verifications, and valuations. Generally, financial information should be
updated not less than annually (loan officer files should be updated as needed
and document all significant meetings and events). Credit information should be
analyzed by management so that appropriate and timely actions are taken, as
necessary, to administer the credit.
Cash Flow Analysis
History has clearly demonstrated that
significant problems can develop when banks fail to pay sufficient attention to
cash flow adequacy in underwriting agricultural loans. While collateral coverage
is important, the primary repayment source for intermediate- and long-term
agricultural loans is not collateral but cash flow from ordinary operations.
This principle should be incorporated into the bank's agricultural lending
policies and implemented in its actual practices. Cash flow analysis is
therefore an important aspect of the examiner's review of agricultural loans.
Assumptions in cash flow projections should be reasonable and consider not only
current conditions but also the historical performance of the farming operation
under review.
Collateral Support
Whether a loan or line of credit warrants
unsecured versus secured status in order to be prudent and sound is a matter the
examiner has to determine on the basis of the facts of the specific case. The
decision should generally consider such elements as the borrower's overall
financial strength and trends, profitability, financial leverage, degree of
liquidity in asset holdings, managerial and financial expertise, and amount and
type of credit. Nonetheless, as a general rule, intermediate- and long-term
agricultural credit is typically secured, and many times production and feeder
livestock advances will also be collateralized. Often the security takes the
form of an all-inclusive lien on farm personal property, such as growing crops,
machinery and equipment, livestock, and harvested grain. A lien on real estate
is customarily taken if the loan was granted for the purchase of the property,
or if the borrower's debts are being restructured because of debt servicing
problems. In some cases, the bank may perfect a lien on real estate as an
abundance of caution measure.
Structuring
Orderly liquidation of agricultural debt, based on an
appropriate repayment schedule and a clear understanding by the borrower of
repayment expectations, helps prevent collection problems from developing.
Amortization periods for term indebtedness should correlate with the useful
economic life of the underlying collateral and with the operation's debt service
capacity. A too-lengthy amortization period can leave the bank under secured in
the latter part of the life of the loan, when the borrower's financial
circumstances may have changed. A too-rapid amortization, on the other hand, can
impose an undue burden on the cash flow capacity of the farming operation and
thus lead to loan default or disruption of other legitimate financing needs of
the enterprise. It is also generally preferable that separate loans or lines of
credit be established for each loan purpose category financed by the
institution.
Administration Of Agricultural Loans
Collateral Control
Production and feeder livestock loans are
sometimes referred to as self liquidating because sale of the crops after
harvest, and of the livestock when they reach maturity, provides a ready
repayment source for these credits. These self-liquidating benefits may be lost,
however, if the bank does not monitor and exercise sufficient control over the
disposition of the proceeds from the sale of these commodities. In agricultural
lending, collateral control is mainly accomplished by periodic on-site
inspections and verifications of the security pledged, with the results of those
inspections documented, and by implementing procedures to ensure sales proceeds
are applied to the associated debt before those proceeds are released for other
purposes. The recommended frequency of collateral inspections varies depending
upon such things as the nature of the farming operation, the overall soundness
of the credit, and the turnover rate of grain and livestock inventories.
Renewal Of Production Loans
After completion of the harvest, some
farm borrowers may wish to defer repayment of some or all of that season's
production loans, in anticipation of higher market prices at a later point
(typically, crop prices are lower at harvest time when the supply is greater).
Such delayed crop marketing will generally require extensions or renewals of the
production loans. In these situations, the bank must strike an appropriate
balance of, on the one hand, not interfering with the debtor's legitimate
managerial decisions and marketing plans while, at the same time, taking prudent
steps to ensure its production loans are adequately protected and repaid on an
appropriate basis. Examiners should generally not take exception to reasonable
renewals or extensions of production loans when the following factors are
favorably resolved: (i) The borrower has sufficient financial strength to absorb
market price fluctuations. Leverage and liquidity in the balance sheet,
financial statement trends, profitability of the operation, and past repayment
performance are relevant indices. (ii) The borrower has sufficient financial
capacity to support both old and new production loans. That is, in a few months
subsequent to harvest, the farmer will typically be incurring additional
production debt for the upcoming crop season. (iii) The bank has adequately
satisfied itself of the amount and condition of grain in inventory, so that the
renewed or extended production loans are adequately supported. Generally, this
means that a current inspection report will be available.
Classification Guidelines For Agricultural Credit
Feeder Livestock Loans
The self-liquidating nature of these credits
means that they are generally not subject to adverse classification. However,
declines in livestock prices, increases in production costs, or other
unanticipated developments may result in the revenues from the sale of the
livestock not being adequate to fully repay the loans. Adverse classification
may then be appropriate, depending upon the support of secondary repayment
sources and collateral, and the borrower's overall financial condition and
trends.
Production Loans
These loans are generally not subject to adverse
classification if the debtor has good liquidity and/or significant fixed asset
equities, or if the cash flow information suggests that current year's
operations should be sufficient to repay the advances. The examiner should also
take into account any governmental support programs or federal crop insurance
benefits from which the borrower may benefit. If cash flow from ongoing
operations appears insufficient to repay production loans, adverse
classification may be in order, depending upon the secondary repayment sources
and collateral, and the borrower's overall financial condition and trends.
Breeder Stock Loans
These loans are generally not adversely
classified if they are adequately secured by the livestock and if the term debt
payments are being met through the sale of offspring (or milk and eggs in the
case of dairy and poultry operations). If one or both of these conditions is not
met, adverse classification may be in order, depending upon the support of
secondary repayment sources and collateral, and the borrower's overall financial
condition and trends.
Machinery And Equipment Loans
Loans for the acquisition of
machinery and equipment will generally not be subject to adverse classification
if they are adequately secured, structured on an appropriate amortization
program (see above), and are paying as agreed. Farm machinery and equipment is
often the second largest class of agricultural collateral, hence its existence,
general state of repair, and valuation should be verified and documented during
the bank's periodic on-site inspections of the borrower's operation. Funding for
the payments on machinery and equipment loans sometimes comes, at least in part,
from other loans provided by the bank, especially production loans. When this is
the case, the question arises whether the payments are truly being "made as
agreed". For examination purposes, such loans will be considered to be paying as
agreed if cash flow projections, payment history, or other available
information, suggests there is sufficient capacity to fully repay the production
loans when they mature at the end of the current production cycle. If the
machinery and equipment loan is not adequately secured, or if the payments are
not being made as agreed, adverse classification of the loan should be
considered. As with other types of agricultural credit, the decision to
adversely classify such loans must take into account the support of secondary
repayment sources and collateral, and the borrower's overall financial condition
and trends.
Carryover Debt
Carryover debt results from the debtor's inability
to generate sufficient cash flow to service the obligation as it is currently
structured. It therefore tends to contain a greater degree of credit risk and
must receive close analysis by the examiner. When carryover debt arises, the
bank should determine the basic viability of the borrower's operation, so that
an informed decision can be made on whether debt restructuring is appropriate.
It will thus be useful for bank management to know how the carryover debt came
about: Did it result from the obligor's financial, operational or other
managerial weaknesses; from inappropriate credit administration on the bank's
part, such as over lending or improper debt structuring; from external events
such as adverse weather conditions that affected crop yields; or from other
causes? In many instances, it will be in the long-term best interests of both
the bank and the debtor to restructure the obligations. The restructured
obligation should generally be rescheduled on a term basis and require clearly
identified collateral, amortization period, and payment amounts. The
amortization period may be intermediate or long term depending upon the useful
economic life of the available collateral, and on realistic projections of the
operation's payment capacity.
Check Credit And Credit Card Loans
Credit Card-related Merchant Activities
Other Credit Issues
Appraisals
Valuation Of Troubled Income-producing Properties
Interagency Appraisal And Evaluation Guidelines
Supervisory Policy
An institution's real estate appraisal and
evaluation policies and procedures will be reviewed as part of the examination
of the institution's overall real estate-related activities. An institution's
policies and procedures should be incorporated into an effective appraisal and
evaluation program. Examiners will consider the institution's size and the
nature of its real estate-related activities when assessing the appropriateness
of its program.
Appraisal And Evaluation Program
An institution's board of
directors is responsible for reviewing and adopting policies and procedures that
establish an effective real estate appraisal and evaluation program. The program
should:
Selection Of Individuals Who May Perform Appraisals And Evaluations
An institution's program should establish criteria to select, evaluate,
and monitor the performance of the individual(s) who performs a real estate
appraisal or evaluation. The criteria should ensure that:
Independence of the Appraisal And Evaluation Function
Because the
appraisal and evaluation process is an integral component of the credit
underwriting process, it should be isolated from influence by the institution's
loan production process. An appraiser and an individual providing evaluation
services should be independent of the loan and collection functions of the
institution and have no interest, financial or otherwise, in the property or the
transaction. If absolute lines of independence cannot be achieved, an
institution must be able to clearly demonstrate that it has prudent safeguards
to isolate its collateral evaluation process from influence or interference from
the loan production process.
Transactions That Require Appraisals
Although the agencies'
appraisal regulations exempt certain categories of real estate-related financial
transactions from the appraisal requirements, most real estate transactions over
$250,000 are considered federally related transactions and thus require
appraisals. A "federally related transaction" means any real estate-related
financial transaction in which the agencies engage, contract for, or regulate,
and that requires the services of an appraiser. An agency also may impose more
stringent appraisal requirements than the appraisal regulations require, such as
when an institution's troubled condition is attributable to real estate loan
underwriting problems.
Minimum Appraisal Standards
The agencies' appraisal regulations
include five minimum standards for the preparation of an appraisal. The
appraisal must:
Appraisal Options
An appraiser typically uses three market value
approaches to analyze the value of a property -- cost, income, and comparable
sales -- and reconciles the results of each to estimate market value. An
appraisal will discuss the property's recent sales history and contain an
opinion as to the highest and best use of the property. An appraiser must
certify that he/she has complied with USPAP and is independent. Also, the
appraiser must disclose whether the subject property was inspected and whether
anyone provided significant assistance to the person signing the appraisal
report.
Transactions That Require Evaluations
A formal opinion of market
value prepared by a State licensed or certified appraiser is not always
necessary. Instead, less formal evaluations of the real estate may suffice for
transactions that are exempt from the agencies' appraisal requirements. The
agencies' appraisal regulations allow an institution to use an appropriate
evaluation of the real estate rather than an appraisal when the transaction:
Evaluation Content
An institution should establish prudent standards
for the preparation of evaluations. At a minimum, an evaluation should:
Qualifications Of Individuals Who Perform Evaluations
Individuals
who prepare evaluations should have real estate-related training or experience
and knowledge of the market relevant to the subject property. Based upon their
experience and training, professionals from several fields may be qualified to
prepare evaluations of certain types of real estate collateral. Examples include
individuals with appraisal experience, real estate lenders, consultants or sales
persons, agricultural extension agents, or foresters. Institutions should
document the qualifications and experience level of individuals whom the
institution deems acceptable to perform evaluations. An institution might also
augment its in-house expertise and hire an outside party familiar with a certain
market or a particular type of property. Although not required, an institution
may use State licensed or certified appraisers to prepare evaluations. As such,
Limited Appraisals reported in a Summary or Restricted format may be appropriate
for evaluations of real estate-related financial transactions exempt from the
agencies' appraisal requirements.
Valid Appraisals And Evaluations
The agencies allow an institution
to use an existing appraisal or evaluation to support a subsequent transaction,
if the institution documents that the existing estimate of value remains valid.
Therefore, a prudent appraisal and evaluation program should include criteria to
determine whether an existing appraisal or evaluation remains valid to support a
subsequent transaction. Criteria for determining whether an existing appraisal
or evaluation remains valid will vary depending upon the condition of the
property and the marketplace, and the nature of any subsequent transaction.
Factors that could cause changes to originally reported values include: the
passage of time; the volatility of the local market; the availability of
financing; the inventory of competing properties; improvements to, or lack of
maintenance of, the subject property or competing surrounding properties;
changes in zoning; or environmental contamination. The institution must document
the information sources and analyses used to conclude that an existing appraisal
or evaluation remains valid for subsequent transactions.
Renewals, Refinancings, And Other Subsequent Transactions
The
agencies' appraisal regulations generally allow appropriate evaluations of real
estate collateral in lieu of an appraisal for loan renewals and refinancings;
however, in certain situations an appraisal is required. If new funds are
advanced in excess of reasonable closing costs, an institution is expected to
obtain a new appraisal for the renewal of an existing transaction when there is
a material change in market conditions or in the physical aspects of the
property that threatens the institution's real estate collateral protection.
Program Compliance
An institution's appraisal and evaluation
program should establish effective internal controls that promote compliance
with the program's standards. An individual familiar with the appropriate
agency's appraisal regulation should ensure that the institution's appraisals
and evaluations comply with the agencies' appraisal regulations, these
guidelines, and the institution's program. Loan administration files should
document this compliance review, although a detailed analysis or comprehensive
analytical procedures are not required for every appraisal or evaluation. For
some loans, the compliance review may be part of the loan officer's overall
credit analysis and may take the form of either a narrative or a checklist.
Corrective action should be undertaken for noted deficiencies by the individual
who prepared the appraisal or evaluation.
Portfolio Monitoring
The institution should also develop criteria
for obtaining reappraisals or reevaluations as part of a program of prudent
portfolio review and monitoring techniques -- even when additional financing is
not being contemplated. Examples of such types of situations include large
credit exposures and out-of-area loans.
Referrals
Financial institutions are encouraged to make referrals
directly to state appraiser regulatory authorities when a State licensed or
certified appraiser violates USPAP, applicable state law, or engages in other
unethical or unprofessional conduct. Examiners finding evidence of unethical or
unprofessional conduct by appraisers will forward their findings and
recommendations to their supervisory office for appropriate disposition and
referral to the state, as necessary.
Recourse Arrangements And Reporting Requirements
All recourse
arrangements should be documented in writing. If a loan is sold with recourse
back to the seller, the selling bank has, in effect, retained the full credit
risk of the loan and its lending limit to the borrower is not reduced by the
amount sold to participants. Participation loans sold with recourse are to be
treated as borrowings of the selling bank from the purchasing bank. Examiners
should consider participations subject to formal or informal repurchase
agreements (or understandings) to be participations "with recourse" regardless
of other wording in the participation agreement to the contrary. The lead bank
may retain, at its exclusive option, the right to repurchase a participating
bank's interest in a loan and still preserve the "without recourse" character of
the participation. In such cases, the agreement should clearly state that the
lead bank is under no obligation to repurchase any participated interest.
Independent Credit Analysis
A bank purchasing a participation loan
is expected to perform the same degree of independent credit analysis of the
loan as if it were the originator. To determine if a participation loan meets
its credit standards, a participating bank must obtain all relevant credit
information and details on collateral values, lien status, loan agreements and
participation agreements before a commitment is made to purchase. The absence of
such information is evidence that the participating bank has not been prudent in
its credit decision.
Participation Agreements
A participation loan can present unique
problems if the borrower defaults, the lead bank becomes insolvent, or a party
to the participation arrangement does not perform as expected. These
contingencies should be considered in a written participation agreement. The
agreement should clearly state the limitations the originating and participating
banks impose on each other and the rights all parties retain. In addition to the
general terms of the participation transaction, participation agreements should
specifically include the following considerations:
Participations Between Affiliated Institutions
Examiners should
ascertain that banks do not relax their credit standards when dealing with
affiliated institutions and that participation loans between affiliated
institutions are in compliance with Section 23A of the Federal Reserve Act. The
Federal Reserve Board Staff has interpreted that the purchase of a participation
loan from an affiliate is exempt from Section 23A provided that (1) the bank's
commitment to purchase is obtained by the affiliate before the loan is
consummated by the affiliate, and (2) the bank's decision to participate is
based upon the bank's independent evaluation of the creditworthiness of the
loan. If these criteria are not strictly met, the loan participation could be
subject to the qualitative and/or quantitative restrictions of Section 23A.
Refer to the Related Organizations Section of this Manual which describes
transactions with affiliates.
Sales Of 100% Loan Participations
Guidelines For An Environmental Risk Program
Failure To Establish Or Enforce Liquidation Agreements
Incomplete Credit Information
Lack Of Attention To Changing Economic Conditions
Potential Problem Indicators By Document
Loan Appraisal And Classification
Loan Appraisal
Substandard
Substandard loans are inadequately protected by the
current sound worth and paying capacity of the obligor or of the collateral
pledged, if any. Loans so classified must have a well-defined weakness or
weaknesses that jeopardize the liquidation of the debt. They are characterized
by the distinct possibility that the bank will sustain some loss if the
deficiencies are not corrected.
Doubtful
Loans classified Doubtful have all the weaknesses inherent
in those classified Substandard with the added characteristic that the
weaknesses make collection or liquidation in full, on the basis of currently
known facts, conditions and values, highly questionable and improbable.
Loss
Loans classified Loss are considered uncollectible and of such
little value that their continuance as bankable assets is not warranted. This
classification does not mean that the loan has absolutely no recovery or salvage
value but rather it is not practical or desirable to defer writing off this
basically worthless asset even though partial recovery may be effected in the
future.
Use Of Special Mention
The Special Mention category is not to be
used as a means of avoiding a clear decision to classify a loan or pass it
without criticism. Neither should it include loans listed merely "for the
record" when uncertainties and complexities, perhaps coupled with large size,
create some reservations about the loan. If weaknesses or evidence of imprudent
handling cannot be identified, inclusion of such loans in Special Mention is not
justified.
Troubled Commercial Real Estate Loan Classification Guidelines
Substandard
Any such troubled real estate loan or portion thereof
should be classified Substandard when well-defined weaknesses are present which
jeopardize the orderly liquidation of the debt. Well-defined weaknesses include
a project's lack of marketability, inadequate cash flow or collateral support,
failure to complete construction on time or the project's failure to fulfill
economic expectations. They are characterized by the distinct possibility that
the bank will sustain some loss if the deficiencies are not corrected.
Doubtful
Doubtful classifications have all the weaknesses inherent
in those classified Substandard with the added characteristic that the
weaknesses make collection or liquidation in full, on the basis of currently
known facts, conditions and values, highly questionable and improbable. A
Doubtful classification may be appropriate in cases where significant risk
exposures are perceived, but loss cannot be determined because of specific
reasonable pending factors which may strengthen the credit in the near term.
Examiners should attempt to identify loss in the credit where possible thereby
limiting the excessive use of the Doubtful classification.
Loss
Advances in excess of calculated current fair value which are
considered uncollectible and do not warrant continuance as bankable assets.
There is little or no prospect for near term improvement and no realistic
strengthening action of significance pending.
Past Due and Nonaccrual
Nonaccrual Loans That Have Demonstrated Sustained Contractual
Performance
Troubled Debt Restructuring (TDR) Multiple Note Structure
Consumer Loan Analysis And Classification
Consumer Instalment Loans
Include open and closed-end credit
extended to individuals for household, family or other personal expenditures as
defined in the Instructions for Preparation of Reports of Condition.
Delinquency
Closed-end instalment credit is considered delinquent
when the borrower is in arrears two monthly payments. Open-end credit is
generally treated differently in computing delinquency. A bank credit card
customer generally has 25 days in which to pay billings before the loan is
considered delinquent. If no payment is made between two billing cycles, the
balance is considered 5 days delinquent. If no payment is received before
issuance of still another statement, the balance is technically 35 days
delinquent, however, current practice is to define accounts with two zero
billings as 30 days delinquent.
Partial Payments
A payment equivalent to 90% or more of the
contractual payment may be considered a full payment in computing delinquency.
Troubled Debt Restructurings, Foreclosures And Repossessions
Transfer Of Assets To The Creditor
Assets received by the bank from
the debtor in full satisfaction of the book value of the bank's loan or security
must be recorded at fair value. Any excess of the recorded investment in a loan
over the fair value of the assets received is a loss to be charged to the
allowance for loan and lease losses; any excess of the recorded investment in
securities over the fair value should be classified as a securities loss.
Modification Of Terms
Whether modification of terms requires a
change in the carrying value of the asset depends upon the total future cash
receipts to be generated under the new terms. If the loan is restructured to the
same borrower and the total amount of future payments under the modified terms
is at least equal to the amount of principal outstanding plus any accrued and
unpaid interest (plus or minus any unamortized premium or discount), FASB 15
requires no immediate recognition of loss, and present value computations under
APBO 21 are not necessary. For example, in lieu of foreclosure, a bank may
choose to add the accrued and unpaid interest to the loan balance and offer a
new note in this amount to the borrower at a less-than-market rate. In this
case, the total amount of future income and principal payments may be greater
than the principal and accrued interest at the time of restructuring. The loss
suffered by the bank is accounted for by the reduced income to be received over
the life of the restructured debt.
Combination Approach
In some instances, the bank may receive assets
in partial rather than full satisfaction of a loan or security and may also
agree to alter the original repayment terms. In these cases, the recorded
investment should be reduced by the fair value of the assets received and the
remaining investment accounted for as a restructuring involving only
modification of terms.
Examination Report Treatment
Examiners may encounter situations in
which troubled debts have been restructured, but the bank has not properly
accounted for the transactions. Where incorrect accounting treatment has
resulted in an over statement of earnings, capital and assets, it will be
necessary to determine the proper carrying values for the restructured assets,
utilizing the best available information developed by the examiner after
consultation with bank management. The unrecognized loss should be reflected in
the examination report as a Loss classification, under the appropriate asset
category.
Other Considerations
Notwithstanding the remarks immediately above,
proper accounting for restructured debts is the responsibility of bank
management. Examiners should not spend a disproportionate amount of time
developing the appropriate accounting entries, but instead discuss with and
request corrective action by bank management when the bank's treatment is not in
accordance with accepted accounting guidelines. It must also be emphasized that
collectability and proper accounting and reporting are separate matters;
restructuring a borrower's debt does not ensure collection of the loan or
security. Adverse classification of restructured obligations should be assigned
if analysis indicates there is risk of loss present. Examiners should take care,
however, not to discourage or be critical of bank management's legitimate and
reasonable attempts to achieve debt settlements through concessionary terms. In
many cases, restructurings offer the only realistic means for a bank to effect
collection of weak or nonearning assets. Finally, the volume of restructured
debts having concessionary interest rates should be considered when evaluating
the bank's earnings performance and assigning the earnings performance rating.
Report Of Examination Treatment Of Classified Loans
Issuance Of "Express Determination" Letters To Banks For Federal Income Tax
Purposes
Tax Rules
The Internal Revenue Code and tax regulations allow a
deduction for a loan that becomes wholly or partially worthless. All pertinent
evidence is taken into account in determining worthlessness. Special tax rules
permit a federally supervised depository institution to elect a method of
accounting under which it conforms its tax accounting for bad debts to its
regulatory accounting for loan charge-offs, provided certain conditions are
satisfied. Under these rules, loans that are charged off pursuant to specific
orders of the institution's supervisory authority or that are classified by the
institution as loss assets under applicable regulatory standards are
conclusively presumed to have become worthless in the taxable year of the
charge-offs. These special tax rules are effective for taxable years ending on
or after December 31, 1991.
Examination Guidelines
Banks are responsible for requesting
"express determination" letters during examinations that cover their loan review
process, i.e., during safety and soundness examinations. Examiners should not
alter the scope or frequency of examinations merely to permit banks to use the
tax-book conformity method.
Federal Funds Sold And Repurchase Agreements
Fundamental Legal Concepts and Definitions
Secured And Unsecured Transactions
Attachment, Security Agreement And Security Interest
Conditions For Attachment
In a secured transaction, the creditor's
security interest consists primarily of two limited rights, the right of
foreclosure and the right of priority. These rights do not attach to the
debtor's property until three conditions have been met, which may be satisfied
in any order. First, both the creditor and debtor must agree the creditor's
security interest is to attach to the collateral. If the creditor's security
interest is to be nonpossessory, the security agreement must be in writing,
signed by the debtor, and contain an adequate description of the collateral. If
the creditor's security interest is to be possessory, the security agreement may
be oral. Second, the debtor must own or otherwise acquire rights in the
collateral offered as security. Third, the creditor gives the debtor value
(ordinarily money) in exchange for the security interest in the debtor's
property. The debtor's rights in a secured transaction hinge on the fact that,
generally, the debtor is considered the general owner of the collateral if and
until sold by the creditor after foreclosure. Thus, the debtor has the following
four basic rights: (1) The right of redemption, or the right to extinguish the
creditor's security interest by repaying the debt; (2) The right to expect
reasonable care of the collateral; (3) The right to surplus (in the case where
the creditor repossesses and sells the goods); and (4) The right to transfer
ownership of the collateral.
Perfection
Once the creditor's security interest has attached, a
lien has been created and the loan is secured. However, the prudent creditor
usually takes steps to further protect its interest vis-a-vis other creditors by
perfecting the security interest. This process in essence puts all other
potential creditors on notice that certain of the debtor's property may be
encumbered. The creditor should perfect its security interest as soon as
possible after attachment because the creditor with the earliest perfected
security interest generally has prior claim if the property must later be sold
to pay the debt. Lien perfection can be effected by taking possession of the
property, filing a copy of the security agreement or financing statement with
the appropriate public official, or, in certain cases, by doing nothing. The
determination as to whether filing is necessary in order to perfect a lien
generally depends upon the type of collateral. Under the UCC, farm products,
inventory, equipment and, in most instances, intangibles require filing in order
to perfect the lien. Purchase money security interests in consumer goods and
farm equipment require no filing (this applies to the latter only if the
purchase price is $2,500 or less). A creditor can perfect by doing nothing only
if the debtor is an "ultimate consumer", that is, has acquired the goods which
serve as collateral for personal use. In cases where filing a copy of the
security agreement or financing statement is required, the filing is good for a
period of five years. The bank may file a continuation statement within six
months prior to the end of the five-year period; if this is not done, the
security interest lapses and its lien becomes unperfected. Filing a continuation
statement continues the effectiveness of the original statement for another
five-year period after the last date on which the filing was effective.
Farm Products Lien Provision
The Food Security Act of 1985
(effective December 26, 1986) makes the "farm products exception" in the UCC
available only if one of two possible procedures are followed. This exception
provides that where the sale of farm products is concerned, a buyer acquires
clear title to the farm products even if they are pledged as collateral to a
loan unless one of two possible procedures are followed: (1) The state can
establish a central filing system which meets the requirements of the
legislation. If a bank properly files with the state under this system, its
security interests in sold farm products will continue; or (2) The state may
alternatively adopt a pre-notification system. Under this approach, a bank must
notify potential buyers of farm products of its security interests.
Special Filing Requirements
The proper filing office varies from
state to state depending on whether filings are made on a local or state-wide
basis or a combination thereof. A peculiarity common to all states is the filing
of a lien on aircraft; the security agreement must be submitted to the Federal
Aviation Administration in Oklahoma City, Oklahoma.
Default and Foreclosure
As a secured party, a bank's rights in
collateral only come into play when the debtor is in default. What constitutes
default varies according to the specific provisions of each promissory note,
loan agreement, security agreement, or other related documents. After a debtor
has defaulted, the creditor usually has the right to foreclose, which means the
creditor seizes the security pledged to the loan, sells it and applies the
proceeds to the unpaid balance of the loan. There may be more than one creditor
claiming a right to the sale proceeds in foreclosure situations. When this
occurs, priority is generally established as follows: (1) Creditors with a
perfected security interest (in the order in which lien perfection was
attained); (2) Creditors with an unperfected security interest; and (3) General
creditors.
Exceptions To The Rule Of Priority
There are three exceptions to
the general rule that the creditor with the earliest perfected security interest
has priority. The first concerns a specific secured transaction in which a
creditor makes a loan to a dealer and takes a security interest in the dealer's
inventory. Suppose such a creditor files a financing statement with the
appropriate public official to perfect the security interest. While it might be
possible for the dealer's customers to determine if an outstanding security
interest already exists against the inventory, it would be impractical to do so.
Therefore, an exception is made to the general rule and provides that a buyer in
the ordinary course of business, i.e., an innocent purchaser for value who buys
in the normal manner, cuts off a prior perfected security interest in the
collateral.
Regular Mortgages
The regular mortgage involves only two parties,
the borrower and the lender. The mortgage document encountered in many states
today is referred to as the regular mortgage. It is, in form, a deed or
conveyance of realty by the borrower to the lender followed or preceded by a
description of the debt and the property, and includes a provision to the effect
that the mortgage be released upon full payment of the debt. Content of
additional paragraphs and provisions varies considerably.
Deeds of Trust
In the trust deed, also known as the deed of trust, the
borrower conveys the realty not to the lender but to a third party, a trustee,
in trust for the benefit of the holder of the notes(s) that constitutes the
mortgage debt. The deed of trust form of mortgage has certain advantages, the
principle being that in a number of states it can be foreclosed by trustee's
sale under the power of sale clause without court proceedings.
Equitable Mortgages
As a general rule, any instrument in writing by
which the parties show their intention that realty be held as security for the
payment of a debt, constitutes an equitable mortgage capable of being foreclosed
in a court of equity.
Deeds Absolute Given As Security
Landowners who borrow money may
give as security an absolute deed to the land. "Absolute deed" means a quitclaim
or warranty deed such as is used in an ordinary realty sale. On its face, the
transaction appears to be a sale of the realty, however, the courts treat such a
deed as a mortgage where the evidence shows that the instrument was really
intended only as security for a debt. If such proof is available, the borrower
is entitled to pay the debt and demand reconveyance from the lender, as in the
case of an ordinary mortgage. If the debt is not paid, the grantee must
foreclose as if a regular mortgage had been made.
Consideration Of Bankruptcy Law as it Relates to Collectability of a
Debt
Introduction
Functions Of Bankruptcy Trustees
Voluntary And Involuntary Bankruptcy
Discharge And Objections To Discharge
Transfers Not Timely Perfected Or Recorded