1. Identifying and Accounting for Deteriorating Credits Barbara Falstad Minneapolis Field Office

2. Topics Loan Scoping/ALERT Internal Loan Review Accounting Treatment for Problem Assets

3. Loan Scoping Emphasis on risk areas in loan portfolio Review bank reports, such as: -loan stratification reports - concentration reports -Part 365 exception reports -problem loan and watch list reports -purchased loans Also sample loans for size, previously classified, past due, nonaccrual, insider loans, and sample new loans made since the last exam

4. ALERT Make use of data included in the download -CRE loan types using call report codes Some examiners use Excel to sort data Queries - standard and custom Sort by branch location, loan officer, or origination date to sample new loans Use Loan Portfolio Audit Tools

5. Internal Loan Review System Elements: 1. Qualifications of Loan Review Personnel 2. Independence 3. Frequency of Reviews 4. Scope of Reviews 5. Depth of Reviews 6. Review of Findings and Follow-up 7. Workpaper and Report Distribution Manual of Examination Policies (page 3.2-2)

6. Accounting Treatment for Problem Assets Issues: Nonaccrual Troubled Debt Restructuring (TDR) Impairment Foreclosed Assets (ORE)

7. Nonaccrual Loans An asset should be on nonaccrual status if: Maintained on a cash basis because of deterioration in the financial condition of the borrower Payment in full of principal or interest is not expected, or Principal or interest has been in default for a period of 90 days or more, unless the asset is both well secured and in the process of collection.

8. Restoration to Accrual Status A nonaccrual asset may be restored to accrual status when: None of its principal and interest is due and unpaid, and the bank expects repayment of the remaining contractual principal and interest, or When it otherwise becomes well secured and in the process of collection.

9. Troubled Debt Restructuring (TDR) A restructuring in which a bank, for economic or legal reasons related to a borrower's financial difficulties, grants a concession to the borrower that it would not otherwise consider. The restructuring may include: (1) The transfer from the borrower to the bank of real estate, receivables from third parties, other assets, or an equity interest in the borrower in full or partial satisfaction of the loan (2) A modification of the loan terms, or (3) A combination of the above.

10. TDR (cont.) Accounting & Reporting Standards: FAS 15 – Accounting by Debtors and Creditors for Troubled Debt Restructurings, as amended by FAS 114 Manual of Examination Policies Call Report Glossary TDR Exam Module

11. TDR (cont.) If new terms of the TDR provide for a reduction of either interest or principal, the institution should measure any loss on the restructuring in accordance with the Call Report Glossary entry for "loan impairment.”

12. TDR (cont.) Examiners should take care 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 bring about collection of weak or non-earning assets.

13. Loan Impairment A loan is impaired when, based on current information and events, it is probable that an institution will be unable to collect all amounts due according to the contractual terms of the loan agreement (i.e., principal and interest). When a loan is deemed impaired under FAS 114, an institution should choose to measure impairment using: 1. Loan’s present value of expected future cash flows discounted at the loan's effective interest rate, 2. Loan's observable market price, or 3. Fair value of the collateral.

14. Loan Impairment (cont.) A loan is collateral dependent if: – repayment of the loan is expected to be provided solely by the underlying collateral, and – no other available and reliable sources of repayment. A creditor should consider estimated costs to sell, on a discounted basis, in the measurement of impairment if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan.

15. Foreclosed Assets – Other Real Estate (ORE) All RE, other than premises, owned or controlled by bank Includes RE acquired through foreclosure even if title has not yet been received Includes foreclosed real estate sold under contract, accounted for under deposit method of accounting (FAS 66)

16. ORE Life Cycle Phases Acquisition Holding Period Disposition

17. ORE Acquisition Accounting and reporting standards: FAS 15 - Accounting by Debtors and Creditors for Troubled Debt Restructurings FAS 144 - Accounting for the Impairment or Disposal of Long-Lived- Assets Call Report Glossary Page A-35, Foreclosed Assets

18. ORE Acquisition (cont.) Foreclosed real estate received in full satisfaction of a loan should be booked at the lesser of fair value less cost to sell or the loan book balance. If recorded amount of loan exceeds fair value less cost to sell, then charge-off difference to ALLL at time of foreclosure Any senior debt should be reported as a liability Legal fees and other direct costs should be expensed as incurred.

19. ORE Holding Period Treatment of holding period costs Covered by basic accounting standards FAS 34 – Capitalization of Interest Cost, as amended by FAS 144 FAS 67 – Accounting for Costs and Initial Rental Operations of Real Estate Projects, as amended by FAS 144.

20. ORE Holding Period (cont.) Fair value less cost to sell becomes “cost” of foreclosed ORE Subsequent reduction of fair value less cost to sell must be recognized as a valuation allowance against the ORE parcel through a charge to expense

21. ORE Disposition Accounting guidance is FAS 66, "Accounting for Sales of Real Estate:" Applies to all transactions in which the seller provides financing to the buyer of the real estate Establishes five methods to account for dispositions of real estate. Each method sets forth the manner in which the profit is to be recognized. Any losses on the disposition of real estate should be recognized immediately.

22. ORE Disposition (cont.) Five Accounting Methods: 1. Full Accrual Method 2. Installment Method 3. Cost Recovery Method 4. Reduced-Profit Method 5. Deposit Method Most banks use the full accrual and deposit methods. Will discuss these two methods, details of remaining three methods are in your resource materials. Other three methods recognize a sale and corresponding loan with differing treatment of profit and income recognition.

23. Full Accrual Method Disposition is recorded as a sale Any profit is recognized in full Seller-financed asset is reported as a loan Following conditions must be met to use this method: A sale has been consummated The buyer's initial investment (down payment) per FAS 66 and continuing investment (periodic payments) are adequate to demonstrate a commitment to pay for the property The receivable is not subject to future subordination The usual risks and rewards of ownership have been transferred.

24. FAS 66 (Appendix A) Minimum down payment requirements for use of full accrual method. Land Held for commercial, industrial, or residential development to commence within two years after sale – 20% Held for commercial, industrial, or residential development to commence after two years – 25% Commercial and Industrial Property Office and industrial buildings, shopping centers, and so forth: – Properties subject to lease on a long-term lease basis to parties with satisfactory credit rating; cash flow currently sufficient to service all indebtedness – 10% – Single-tenancy properties sold to a buyer with a satisfactory credit rating – 15% – All other – 20%

25. FAS 66 (Appendix A) (cont.) Commercial and Industrial Property (cont’) Other income-producing properties (hotels, motels, marinas, mobile home parks, and so forth): – Cash flow currently sufficient to service all indebtedness – 15% – Start-up situations or current deficiencies in cash flow – 25% Multifamily Residential Property Primary residence: – Cash flow currently sufficient to service all indebtedness – 10% – Start-up situations or current deficiencies in cash flow – 15% Secondary or recreational residence: – Cash flow currently sufficient to service all indebtedness – 15% – Start-up situations or current deficiencies in cash flow – 25%

26. FAS 66 (Appendix A) (cont.) Single-Family Residential Property (including condominium or cooperative housing) Primary residence of the buyer – 5% Secondary or recreational residence – 10%

27. Deposit Method Used where a sale of the foreclosed real estate has not been consummated. Sale is not recorded and the asset continues to be reported as foreclosed real estate. No profit or interest income is recognized. Payments received from the borrower are reported as a liability until sufficient payments or other events have occurred which allow the use of one of the other methods.

28. Classification & Reserves ORE Classification: Banks should make periodic reappraisals of other real estate. Any portion of the carrying value in excess of appraised value should be classified Loss. The remaining book value should then be evaluated and adversely classified, if appropriate. ORE Reserves: Reserves on foreclosed properties are not recognized as a component of leverage or risk- based capital.