Large Bank Conference Regulatory Update

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Large Bank Conference Regulatory Update

• Loss-Sharing Agreementsand Related Accounting
  Topics
• Robert Warren
• FDIC Regional Accountant
• Atlanta Regional Office
• Division of Risk Management Supervision
• December 8, 2011

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Loss-Sharing Agreements

• When an acquiring institution has entered into a
  loss sharing agreement with the FDIC in
  connection with an acquisition of a failed
  financial institution
• The assets covered by the loss sharing agreements
  should be recorded in their respective balance
  sheet categories (i.e., loans, OREO, securities)
• The loss sharing agreement should be valued and
  recorded separately on the face of the balance
  sheet or grouped within other assets if not
  material
• Call Report Schedule RC-F (All Other Assets),
  item 6.e. (FDIC loss-sharing indemnification
  assets)

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Loss-Sharing Agreements

• Accounting for the FDIC loss-sharing agreement is
  based on the guidance for indemnification assets
  in ASC Topic 805, Business Combinations
• Initially measure the indemnification asset
  related to the assets covered by the loss-sharing
  agreement in a manner consistent with the initial
  measurement of the indemnified items
• Covered loans and securities are measured at
  acquisition date fair value
• Covered other real estate owned is measured at
  acquisition date fair value less cost to sell

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Loss-Sharing Agreements

• Indemnification asset is measured at acquisition
  date fair value
• Fair value should reflect estimate of the amount
  and timing of the expected future cash flows to
  be received from the FDIC under the agreement
• The assumptions used in estimating the fair value
  of the indemnification asset should be consistent
  with those used to estimate of the fair values of
  the covered assets
• Retrospectively adjust provisional fair value
  estimates to appropriate acquisition date fair
  values to reflect new information about
  acquisition date facts and circumstances obtained
  during the measurement period

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Loss-Sharing Agreements

• Subsequent accounting for indemnification asset
• Measure asset on the same basis as the covered
  assets
• Approach is intended to reduce earnings
  volatility
• Also assess asset for impairment
• Covered loans decrease in expected cash flows
• Results in increase in expected cash flows from
  FDIC under loss-sharing agreement

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Loss-Sharing Agreements

• For a covered purchased credit-impaired (PCI)
  loan accounted for under ASC Subtopic 310-30
  (former SOP 03-3)
• Recognize a loan loss allowance and provision
  expense
• Also reclassify portion of accretable yield to
  nonaccretable difference
• Recognize increase in indemnification asset and
  noninterest income for reimbursable percentage of
  decrease in expected cash flows covered by FDIC
• For a covered non-PCI loan accounted for under
  ASC Subtopic 310-20 (former FAS 91)
• Same accounting as above, but without
  reclassification

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Loss-Sharing Agreements

• Covered loans increase in expected cash flows
• Results in decrease in expected cash flows from
  FDIC under loss-sharing agreement
• For a covered PCI loan
• Reduce post-acquisition loan loss allowance, if
  any
• Reclassify portion of nonaccretable difference to
  accretable yield, which will be recognized
  prospectively as an adjustment of loans yield
  over its remaining life
• For a covered non-PCI loan
• Reduce post-acquisition loan loss allowance, if
  any
• No other entry needed, which means that cash flow
  increase will be recognized prospectively in
  income

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Loss-Sharing Agreements

• Impact of decrease in expected cash flows from
  FDIC on indemnification asset possible
  accounting alternatives
• Recognize decrease as an impairment of
  indemnification asset and a charge to noninterest
  income/expense
• Does not produce income statement symmetry with
  accounting for covered loan, i.e., same basis
  accounting not achieved
• OR

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Loss-Sharing Agreements

• Recognize decrease prospectively through
  reduction of undiscounted expected cash flows
  from FDIC, thereby reducing discount on
  indemnification asset and yield used to accrete
  discount over assets remaining life (i.e., no
  change in assets carrying amount)
• Achieves income statement symmetry with
  accounting for covered loan
• However, may result in a negative discount and
  negative yield (i.e., indemnification assets
  carrying amount exceeds undiscounted expected
  cash flows from FDIC)

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Loss-Sharing Agreements

• The allowance for loan losses should be
  determined without giving consideration to the
  loss sharing agreement (since the loss sharing
  agreement is separately accounted for and thus
  gross on the balance sheet)
• The provision for loan losses may be net of
  changes in the amount receivable from the loss
  sharing agreement, with appropriate disclosure of
  the effects of the loss sharing agreement on the
  provision for loan losses
• For Call Reports proposes, these amounts should
  be reported separately and not netted

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Loss-Sharing Agreements

• True-up Payments under Loss-Sharing Agreements
  (a/k/a claw-back provision)
• Agreement may require acquiring institution to
  reimburse the FDIC when loss-sharing ends if
  FDICs initially estimated losses on covered
  assets are overstated and actual realized losses
  are less

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Loss-Sharing Agreements
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Loss-Sharing Agreements

• True-up Payments (cont.)
• Obligation for payment represents a form of
  contingent consideration under ASC Topic 805,
  Business Combinations
• At initial recognition as of acquisition date,
  measure obligation at fair value
• Fair value is part of consideration transferred
  by acquirer to acquire the failed institution,
  which reduces bargain purchase gain (or goodwill)
  
• Report obligation as a liability
• Do not net liability against indemnification
  asset
• Subsequently measure obligation at fair value,
  with changes in fair value recognized in earnings

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Loss-Sharing Agreements

• No carryover of ALLL at acquisition
• Do not recognize an ALLL for the contractual cash
  flows on the acquired loans that are deemed to be
  uncollectible at the acquisition date
• Uncertainty about the future cash flows are
  included in their estimated acquisition-date fair
  values
• Establish loan loss allowances for acquired
  held-for-investment loans in periods after the
  acquisition date
• But only for losses incurred due to credit
  deterioration after acquisition

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Loss-Sharing Agreements

• Subsequent (Day 2) Loan Accounting
• ASC Subtopic 310-30, Loans and Debt Securities
  acquired with Deteriorated Credit Quality (SOP
  03-3)
• Purchased Credit Impaired (PCI) Loans
• Subtopic 310-10, Receivables Overall (FAS 114)
• Subtopic 450-20, Contingencies Loss
  Contingencies (FAS 5)

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Purchased Credit Impaired Loans

• ASC Subtopic 310-30, Receivables - Loans and
  Debt Securities Acquired with Deteriorated Credit
  Quality (formerly AICPA SOP 03-3)
• Applies to purchased credit impaired loans (PCI
  loans), i.e., individual loans with evidence of
  deterioration of credit quality since origination
  acquired by completion of a transfer for which it
  is probable, at acquisition, that the investor
  will be unable to collect all contractually
  required payments receivable

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Purchased Credit Impaired Loans

• Aggregation under ASC Subtopic 310-30
• Investors may aggregate individual PCI loans
  acquired in same fiscal quarter that have common
  risk characteristics and account for them as a
  pool
• Upon establishment of the pool, the pool becomes
  the unit of account
• Purchase discount is not allocated to individual
  loans
• All of the loans in the pool accrete at a single
  pool (composite) interest rate based on the cash
  flow projections for the pool
• Impairment analysis is performed on the pool as a
  whole rather than for each individual loan

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Purchased Credit Impaired Loans

• Aggregation under ASC Subtopic 310-30 (cont.)
• On an ongoing basis, investor should estimate
  cash flows expected to be collected on the loans
  in the pool over the life of the pool
• If, upon evaluation, it is probable based on
  current information and events that investor is
  unable to collect all cash flows expected at
  acquisition on the loans in the pool, the pool
  should be considered impaired and an allowance
  for post-acquisition credit losses should be
  established
• Plus any additional cash flows expected to be
  collected on the loans in the pool arising from
  previous changes in estimate after acquisition

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Purchased Credit Impaired Loans

• Aggregation under ASC Subtopic 310-30 (cont.)
• Once a pool is assembled, integrity of pool
  should be maintained
• A loan should be removed from a pool only if the
  investor receives assets in satisfaction of the
  loan (e.g., though foreclosure) or the loan is
  sold or written off, and the loan should be
  removed at its carrying amount
• Per ASU No. 2010-18, issued April 2010, a
  modification of a PCI loan accounted for within a
  pool does not result in the removal of the loan
  from the pool even if the modification would
  otherwise be considered a troubled debt
  restructuring

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Purchased Credit Impaired Loans

• Aggregation under ASC Subtopic 310-30 (cont.)
• Investor must consider whether the modification
  of the PCI loan in the pool results in a change
  in cash flows expected to be collected on the
  loans in the pool over the life of the pool,
  i.e., impairment or additional impairment
• PCI loans accounted for individually (i.e., not
  as part of a pool) under Subtopic 310-30 are
  subject to the troubled debt restructuring
  accounting provisions of Subtopic 310-40,
  Receivables - Troubled Debt Restructurings by
  Creditors

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Purchased Credit Impaired Loans

• Reporting PCI loans as past due or nonaccrual in
  the Call Report
• PCI loan accounted for individually
• When accrual of income is appropriate, determine
  delinquency status of loan in accordance with its
  contractual repayment terms
• When accrual of income is not appropriate, place
  loan in - and report loan as being in -
  nonaccrual status

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Purchased Credit Impaired Loans

• Reporting PCI loans as past due or nonaccrual in
  the Call Report (cont.)
• PCI loans accounted for on a pool basis
• When accrual of income on pool is not
  appropriate, place entire pool in - and report
  entire pool as being in - nonaccrual status
• When accrual of income on pool is appropriate,
  determine delinquency status of individual loans
  in the pool - and report individual loans in the
  pool as past due - in accordance with each loans
  contractual repayment terms
• Do not report individual loans in the pool as
  nonaccrual

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Adverse Classification of Assets Covered by LSA

• Day 1
• Book Value at Failed Institution 100,000
• Credit Loss Estimate 20,000
• FV to Acquiring Institution (AI) 80,000
• AI Carrying Amt
• At acquisition AI books an Indemnification
  Asset 16,000
• (20,000 x 80)
• The AI does not book an allowance on Day 1. The
  uncertainty about the future cash flows on the
  acquired loan, including collectability concerns,
  was included in estimated acquisition-date FV
• Day 2
• There has been further deterioration on the
  acquired loan. The AI does not expect to
  collect an additional 10,000
• At the time of the examination the bank has not
  accounted for the credit impairment in the
  allowance. Before considering the LSA,
  examiners would classify the loan as follows
  Assume the Carrying Amt of Loan is 80,000
• Substandard 70,000
• Loss 10,000

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Adverse Classification of Assets Covered by LSA

• After considering LSA, examiners would show the
  following classified amounts
• Substandard 70,000 (20) 14,000
• Loss 10,000 (20) 2,000
• Entries required by Bank for Call Report
• Indemnification Asset 8,000
• Other Operating Income 8,000
• (increase in FDIC receivable for additional
  10,000 covered loss)
• Provision Loan and Lease Losses 10,000
• Allowance for Loan Losses 10,000
• (provision expense/charge-off for additional
  impairment)

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Best Practices

• Fair Value evaluations by qualified, independent
  party
• Accounting consultations from qualified,
  independent party
• Internal Audit by qualified party
• Procedures and systems for purchased impaired
  loans (ASC 310-30/SOP 3-03)
• Written policies and procedures to account for
• losses on covered loans after acquisition
• indemnification asset

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Questions??