Section 3-2 Loans

LOANS Section 3.2

RMS Manual of Examination Policies 3.2-1 Loans (07-24)

Federal Deposit Insurance Corporation

INTRODUCTION.............................................................. 3

LOAN ADMINISTRATION ............................................. 3

Lending Policies ............................................................. 3

Loan Review Systems .................................................... 4

Credit Risk Rating or Grading Systems ..................... 4

Loan Review System Elements .................................. 5

Current Expected Credit Losses (CECL) ....................... 6

Allowance for Loan and Lease Losses (ALLL) ............. 6

Responsibility of the Board and Management ........... 7

Factors to Consider in Estimating Credit Losses........ 7

Examiner Responsibilities .......................................... 8

Regulatory Reporting of the ALLL ............................ 8

Accounting and Reporting Treatment ........................ 8

PORTFOLIO COMPOSITION .......................................... 9

Commercial Loans ......................................................... 9

General ....................................................................... 9

Accounts Receivable Financing ................................... 10

Leveraged Lending ....................................................... 11

Applicability ............................................................. 11

General ..................................................................... 11

Risk Management Framework ................................. 12

General Policies ....................................................... 12

Participations Purchased .......................................... 12

Underwriting Standards............................................ 12

Credit Analysis ......................................................... 13

Valuation Standards ................................................. 13

Risk Rating Leveraged Loans .................................. 14

Problem Credit Management.................................... 14

Reporting and Analytics ........................................... 15

Deal Sponsors........................................................... 15

Independent Credit Review ...................................... 16

Stress Testing ........................................................... 16

Conflicts of Interest .................................................. 16

Oil and Gas Lending .................................................... 16

Industry Overview .................................................... 16

Reserve-Based Lending ............................................ 17

Real Estate Loans ......................................................... 22

General ..................................................................... 22

Real Estate Lending Standards ................................. 22

Commercial Real Estate Loans ................................ 23

Real Estate Construction Loans ............................... 24

Home Equity Loans ...................................................... 25

Agricultural Loans ....................................................... 26

Introduction .............................................................. 26

Agricultural Loan Types and Maturities .................. 26

Agricultural Loan Underwriting Guidelines ............ 27

Administration of Agricultural Loans ...................... 28

Classification Guidelines for Agricultural Credit ..... 29

Installment Loans ......................................................... 30

Lease Accounting ......................................................... 31

Direct Lease Financing............................................. 31

Lessor Accounting under ASC Topic 840................ 31

Lessor Accounting under ASC Topic 842................ 31

Examiner Consideration ........................................... 32

Floor Plan Loans .......................................................... 32

Check Credit and Credit Card Loans ........................... 32

Credit Card-related Merchant Activities ...................... 33

OTHER CREDIT ISSUES .............................................. 34

Appraisals .................................................................... 34

Valuation of Troubled Income-Producing Properties

................................................................................. 35

Appraisal Regulation ............................................... 35

Interagency Appraisal and Evaluation Guidelines ... 37

Examination Treatment ........................................... 41

Loan Participations ...................................................... 41

Accounting .............................................................. 41

Right to Repurchase ................................................. 42

Recourse Arrangements ........................................... 42

Call Report Treatment ............................................. 42

Independent Credit Analysis .................................... 43

Participation Agreements ......................................... 43

Participations Between Affiliated Institutions ......... 43

Sales of 100 Percent Loan Participations................. 43

Environmental Risk Program ...................................... 44

Elements of an Effective Environmental Risk

Program ................................................................... 44

Examination Procedures .......................................... 46

LOAN PROBLEMS ........................................................ 46

Poor Selection of Risks ................................................ 47

Overlending ................................................................. 47

Failure to Establish or Enforce Liquidation Agreements

..................................................................................... 47

Incomplete Credit Information .................................... 47

Overemphasis on Loan Income ................................... 47

Self-Dealing ................................................................. 47

Technical Incompetence .............................................. 48

Lack of Supervision ..................................................... 48

Lack of Attention to Changing Economic Conditions . 48

Competition ................................................................. 48

Potential Problem Indicators by Document ................. 48

SELECTING A LOAN REVIEW SAMPLE IN A RISK-

FOCUSED EXAMINATION .......................................... 49

Assessing the Risk Profile ........................................... 49

Selecting the Sample ................................................... 49

Nonhomogeneous Loan Sample .............................. 50

Homogeneous Pool Sample ..................................... 50

Determining the Depth of the Review ......................... 50

Adjusting Loan Review ............................................... 51

Accepting an Institution’s Internal Ratings ................. 51

Loan Penetration Ratio ................................................ 51

Large Bank Loan Review ............................................ 51

LOAN EVALUATION AND CLASSIFICATION ........ 52

Loan Evaluation ........................................................... 52

Review of Files and Records ....................................... 52

Additional Transaction Testing ............................... 52

Loan Discussion .......................................................... 52

Loan Analysis .............................................................. 53

Loan Classification ...................................................... 53

Definitions ................................................................... 53

Special Mention Assets................................................ 54

Technical Exceptions ................................................... 54

Past Due and Nonaccrual ............................................. 54

LOANS Section 3.2

Loans (07-24) 3.2-2 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation

Nonaccrual Loans That Have Demonstrated Sustained

Contractual Performance .............................................. 55

Troubled Debt Restructuring - Multiple Note Structure

...................................................................................... 55

Interagency Retail Credit Classification Policy............ 56

Re-aging, Extensions, Deferrals, Renewals, or

Rewrites ................................................................... 57

Partial Payments on Open-End and Closed-End

Credit ........................................................................ 58

Examination Considerations .................................... 58

Examination Treatment ............................................ 58

Impaired Loans, Troubled Debt Restructurings,

Foreclosures, and Repossessions .................................. 58

Report of Examination Treatment of Classified Loans 61

Issuance of "Express Determination" Letters to

Institutions for Federal Income Tax Purposes .............. 62

CONCENTRATIONS ...................................................... 63

FEDERAL FUNDS SOLD AND REPURCHASE

AGREEMENTS ............................................................... 64

Assessing Bank-to-Bank Credit ................................... 65

FUNDAMENTAL LEGAL CONCEPTS AND

DEFINITIONS ................................................................. 65

Uniform Commercial Code – Secured Transactions .... 65

General Provisions ................................................... 65

Grant of Security Interest ......................................... 66

Collateral .................................................................. 66

Perfecting the Security Interest ................................ 66

Right to Possess and Dispose of Collateral .............. 66

Agricultural Liens .................................................... 66

Borrowing Authorization ............................................. 68

Bond and Stock Powers................................................ 68

Co-maker ...................................................................... 68

Loan Guarantee ............................................................ 68

Subordination Agreement ............................................ 69

Hypothecation Agreement ............................................ 69

Real Estate Mortgage ................................................... 69

Collateral Assignment .................................................. 70

CONSIDERATION OF BANKRUPTCY LAW AS IT

RELATES TO COLLECTIBILITY OF A DEBT ........... 70

Introduction .................................................................. 70

Forms of Bankruptcy Relief ......................................... 70

Functions of Bankruptcy Trustees ................................ 71

Voluntary and Involuntary Bankruptcy ........................ 71

Automatic Stay ............................................................. 71

Property of the Estate ................................................... 71

Discharge and Objections to Discharge ....................... 71

Reaffirmation ............................................................... 72

Classes of Creditors ...................................................... 72

Preferences ................................................................... 72

Setoffs .......................................................................... 72

Transfers Not Timely Perfected or Recorded ............... 73

SYNDICATED LENDING.............................................. 73

Overview ...................................................................... 73

Syndication Process ..................................................... 73

Loan Covenants ............................................................ 74

Credit Rating Agencies ................................................ 74

Overview of the Shared National Credit (SNC) Program

..................................................................................... 74

Definition of a SNC ................................................. 75

SNC Review and Rating Process ............................. 75

SNC Rating Communication and Distribution Process

................................................................................. 75

Appeals Process ....................................................... 75

Additional Risks Associated with Syndicated Loan

Participations ............................................................... 76

CREDIT SCORING ........................................................ 76

SUBPRIME LENDING .................................................. 77

Introduction ................................................................. 77

Capitalization ............................................................... 78

Stress Testing ............................................................... 79

Risk Management ........................................................ 79

Classification ............................................................... 82

ALLL Analysis ............................................................ 82

Subprime Auto Lending .............................................. 82

Subprime Residential Real Estate Lending.................. 83

Subprime Credit Card Lending .................................... 83

Payday Lending ........................................................... 83

General .................................................................... 84

Underwriting ............................................................ 84

Payday Lending Through Third Parties ................... 84

Concentrations ......................................................... 85

Capital Adequacy .................................................... 85

Allowance for Loan and Lease Losses .................... 85

Classifications .......................................................... 86

Renewals/Rewrites .................................................. 86

Accrued Fees and Finance Charges ......................... 86

Recovery Practices .................................................. 86

GOVERNMENT GUARANTEED LENDING AND

GOVERNMENT INSURED MORTGAGE LENDING . 87

Overview ..................................................................... 87

Risks in GGL ............................................................... 87

Delegated Authority Lender ........................................ 89

Agency Audit or Reviews ............................................ 89

Guarantee Purchase/ Loss Claim Payment .................. 89

Loan Sales ................................................................... 90

Risk Management Framework ..................................... 91

Policies and Procedures ........................................... 91

Management and Personnel ..................................... 91

Concentrations ......................................................... 92

Allowance for Credit Losses (ACL) ........................ 92

Credit Risk Rating and Loan Classifications ........... 93

LOANS Section 3.2

RMS Manual of Examination Policies 3.2-3 Loans (07-24)

Federal Deposit Insurance Corporation

INTRODUCTION

Section 39 of the Federal Deposit Insurance Act, Standards

for Safety and Soundness, requires each federal banking

agency to establish safety and soundness standards for all

insured depository institutions. Appendix A to Part 364 of

the FDIC Rules and Regulations, Interagency Guidelines

Establishing Standards for Safety and Soundness, sets out

the safety and soundness standards that the agencies use to

identify and address problems at insured depository

institutions before capital becomes impaired. Operational

and managerial safety and soundness standards pertaining

to an institution’s loan portfolio address areas such as asset

quality, internal controls, credit underwriting, and loan

documentation.

The examiner’s evaluation of an institution’s lending

policies, credit administration, and the quality of the loan

portfolio is among the most important aspects of the

examination process. To a great extent, the quality of an

institution's loan portfolio determines the risk to depositors

and to the FDIC's insurance fund. Conclusions regarding

the institution’s condition and the quality of its management

are weighted heavily by the examiner's findings with regard

to lending practices. Emphasis on review and evaluation of

the loan portfolio and its administration by institution

management during examinations recognizes that loans

comprise a major portion of most institutions’ assets; and,

that it is the asset category which ordinarily presents the

greatest credit risk and potential loss exposure to banks.

Moreover, pressure for increased profitability, liquidity

considerations, and a more complex society produce great

innovations in credit instruments and approaches to lending.

Loans have consequently become more complex.

Examiners therefore find it necessary to devote a large

portion of time and attention to loan portfolio examination.

←

LOAN ADMINISTRATION

Lending Policies

The examiner's evaluation of the loan portfolio involves

much more than merely appraising individual loans.

Prudent management and administration of the overall loan

account, including establishment of sound lending and

collection policies, are of vital importance if the institution

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. The board of directors of

every institution is responsible for formulating lending

policies and to supervise their implementation. Therefore

examiners should encourage establishment and

maintenance of written, up-to-date lending policies which

have been approved by the board of directors. A 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

institution's customers as well as changes that may occur

within the institution itself. To a large extent, the economy

of the community served by the institution dictates the

composition of the loan portfolio. 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 are typically addressed in the lending policies

of all banks regardless of size or location. These include the

following:

• General fields of lending in which the institution will

engage and the kinds or types of loans within each

general field;

• Lending authority of each loan officer;

• Lending authority of a loan or executive committee, if

any;

• Responsibility of the board of directors in reviewing,

ratifying, or approving loans;

• Guidelines under which unsecured loans will be

granted;

• Guidelines for rates of interest and the terms of

repayment for secured and unsecured loans;

• Limitations on the amount advanced in relation to the

value of the collateral and the documentation required

by the institution for each type of secured loan;

• Guidelines for obtaining and reviewing real estate

appraisals as well as for ordering reappraisals, when

needed;

• Maintenance and review of complete and current

credit files on each borrower;

• Appropriate collection procedures including, but not

limited to, actions to be taken against borrowers who

fail to make timely payments;

• Limitations on the maximum volume of loans in

relation to total assets;

• Limitations on the extension of credit through

overdrafts;

• Description of the institution's normal trade area and

circumstances under which the institution may extend

credit outside of such area;

• Guidelines that address the goals for portfolio mix and

risk diversification and cover the institution's plans for

monitoring and taking appropriate corrective action, if

deemed necessary, on any concentrations that may

exist;

• Guidelines addressing the institution's loan review and

grading system ("Watch list");

LOANS Section 3.2

Loans (07-24) 3.2-4 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation

• Guidelines addressing the institution's review of the

Allowance for Loan and Lease Losses (ALLL) or

ACL for loans and leases, as appropriate; and

• Guidelines for adequate safeguards to minimize

potential environmental liability.

Note: The allowance for credit losses on loans and leases

or ACL for loans and leases is the term used for those banks

that adopted ASU 2016-13, which implements ASC Topic

326, Financial Instruments – Credit Losses replacing the

allowance for loan losses used under the incurred loss

methodology.

The above are only guidelines for areas that should be

considered during the loan 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 institution's Board 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

institution'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 institution's lending

policies. Guidelines for their consideration are discussed

under the appropriate areas.

Loan Review Systems

The terms loan review system or credit risk review system

refer 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 appropriateness of the ALLL or ACL for loans

and leases.

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 have

an effective loan review system. Regardless of its

complexity, an effective loan review system is generally

designed to address the following objectives:

• To promptly identify loans with well-defined credit

weaknesses so that timely action can be taken to

minimize credit loss;

• To provide essential information for determining the

appropriateness of the ALLL or ACL for loans and

leases;

• To identify relevant trends affecting the collectibility

of the loan portfolio and isolate potential problem

areas;

• To evaluate the activities of lending personnel;

• To assess the adequacy of, and adherence to, loan

policies and procedures, and to monitor compliance

with relevant laws and regulations;

• To provide the board of directors and senior

management with an objective assessment of the

overall portfolio quality; and

• To provide management with information related to

credit quality that can be used for financial and

regulatory reporting purposes.

Credit Risk Rating or Grading Systems

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 an

allowance when evaluating specific credits and for the

determination of an overall ALLL or ACL for loans and

leases, as appropriate.

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, loan committee(s), or other internal or external

credit review specialists. Credit grading reviews performed

by individuals independent of the lending function are

preferred because they can often provide a more objective

assessment of credit quality. A loan review system typically

includes the following:

• A formal credit grading system that can be reconciled

with the framework used by federal regulatory

agencies;

• An identification of loans or loan pools that warrant

special attention;

• A mechanism for reporting identified loans, and any

corrective action taken, to senior management and the

board of directors; and

• Documentation of an institution’s credit loss

experience for various components of the loan and

lease portfolio.

LOANS Section 3.2

RMS Manual of Examination Policies 3.2-5 Loans (07-24)

Federal Deposit Insurance Corporation

Loan Review System Elements

Loan review policies are typically reviewed and approved

at least annually by the board of directors. Policy guidelines

include a written description of the overall credit grading

process, and establish responsibilities for the various loan

review functions. The policy generally addresses the

following items:

• 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; and

• Workpaper and report distribution.

Qualifications of Loan Review Personnel

Personnel to involve in the loan review function are

qualified based on level of education, experience, and extent

of formal training. They are knowledgeable of both sound

lending practices and their own institution’s specific lending

guidelines. In addition, they are knowledgeable of pertinent

laws and regulations that affect lending activities.

Loan Review Personnel I

ndependence

Loan officers are generally 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. To avoid conflicts of interest, management

typically ensures 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, a

committee of outside directors, or an outside loan review

consultant fill this role. Regardless of the method used, loan

review personnel should report their findings directly to the

board of directors or a board committee.

Frequency of Reviews

The loan review function provides feedback on the

effectiveness of the lending process in identifying emerging

problems. Reviews of significant credits are generally

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

process of determining the ALLL or the ACL for loans and

leases, as appropriate.

Scope of Reviews

Reviews typically 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 as a troubled

debt, 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.

Depth of Reviews

Loan reviews typically analyze a number of important credit

factors, including:

• Credit quality;

• Sufficiency of credit and collateral documentation;

• Proper lien perfection;

• Proper loan approval;

• Adherence to loan covenants;

• Compliance with internal policies and procedures, and

applicable laws and regulations; and

• The accuracy and timeliness of credit grades assigned

by loan officers.

Review of Findings and Follow-up

Loan review findings should be reviewed with appropriate

loan officers, department managers, and members of senior

management. Typically, any existing or planned corrective

action (including estimated timeframes) is obtained for all

noted deficiencies, with those deficiencies that remain

unresolved reported to senior management and the board of

directors.

Workpaper and Report Distribution

A list of the loans reviewed, including the review date, and

documentation supporting assigned ratings is commonly

prepared. A report that summarizes the results of the review

is typically submitted to the board at least quarterly.

Findings usually address adherence to internal policies and

procedures, and applicable laws and regulations, so that

deficiencies can be remedied in a timely manner.

LOANS Section 3.2

Loans (07-24) 3.2-6 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation

Examiners should review the written response from

management in response to any substantive criticisms or

recommendations and assess corrective actions taken.

Current Expected Credit Losses (CECL)

The Current Expected Credit Losses (CECL) methodology

as implemented by FASB Accounting Standards

Codification (ASC) Subtopic 326-20, Financial Instruments

– Credit Losses – Measured at Amortized Cost applies to

financial assets measured at amortized cost, net investments

in leases, and off-balance-sheet credit exposures

(collectively, financial assets). For institutions that are SEC

filers, excluding those that are “smaller reporting

companies” as defined in the SEC’s rules, the CECL

methodology is effective for fiscal years beginning January

1, 2020, for institutions with calendar year fiscal years. For

all other institutions, (i.e., non-public institutions),

including those SEC filers that are smaller reporting

companies, CECL will take effect for institutions with

calendar year fiscal years beginning after December 15,

2022, (i.e., January 1, 2023).

The CECL methodology does not apply to financial assets

measured at fair value through net income, including those

assets for which the fair value option has been elected; loans

held-for-sale; policy loan receivables of an insurance entity;

loans and receivables between entities under common

control; and receivables arising from operating leases.

Available-for-sale debt securities are not covered under the

CECL methodology but are covered by ASC Subtopic 326-

30, Financial Instruments – Credit Losses – Available-for-

Sale Debt Securities for institutions that have adopted ASC

Topic 326.

The allowance for credit losses or ACL for loans and leases

is a valuation account that is deducted from, or added to, the

amortized cost basis of financial assets to present the net

amount expected to be collected over the contractual term

of the assets, considering expected prepayments. Renewals,

extensions, and modifications are excluded from the

contractual term of a financial asset for purposes of

estimating the ACL for loans and leases unless there is a

reasonable expectation of executing a troubled debt

restructuring or the renewal and extension options are part

of the original or modified contract and are not

unconditionally cancellable by the institution.

In estimating the net amount expected to be collected,

management should consider the effects of past events,

current conditions, and reasonable and supportable forecasts

on the collectibility of the institution’s financial assets.

Under the CECL methodology, inputs will need to change

in order to achieve an appropriate estimate of expected

credit losses. For example, inputs to a loss rate method

would need to reflect expected losses over the contractual

term, rather than the annual loss rates commonly used under

the existing incurred loss methodology. To properly apply

an acceptable estimation method, an institution’s credit loss

estimates must be well supported.

Similar to the ALLL, the ACL for loans and leases is

evaluated as of the end of each reporting period and reported

in the Consolidated Reports of Condition and Income (Call

Report). The methods used to determine ACLs generally

should be applied consistently over time and reflect

management’s current expectations of credit losses.

Changes to ACL for loans and leases resulting from these

periodic evaluations are recorded through increases or

decreases to the related provisions for credit losses (PCLs).

Throughout this Section 3.2, Loans,

references pertaining

to the ALLL describe the incurred methodology and apply

only to institutions that have not yet adopted ASC Topic 326.

As such, the methodology for impairment contained in ASC

Subtopic 310-10, Receivables - Overall and collective loan

impairment contained in ASC Subtopic 450-20,

Contingencies – Loss Contingencies has been superseded

and is not applicable for institutions that have adopted ASC

Topic 326 (CECL). Therefore, for those institutions that

have adopted CECL, examiners should refer to the Call

Report Glossary entry for “allowance for credit losses” and

the, “Interagency Policy Statement on Credit Losses,”

issued May 8, 2020, via FIL 54-2020, for additional

information on the CECL methodology.

Allowance for Loan and Lease Losses (ALLL)

Each institution must maintain an ALLL that is appropriate

to absorb estimated credit losses associated with the held for

investment loan and lease portfolio, i.e., loans and leases

that the institution has the intent and ability to hold for the

foreseeable future or until maturity or payoff. Each

institution should also maintain, as a separate liability

account, an allowance sufficient to absorb estimated credit

losses associated with off-balance sheet credit instruments

such as loan commitments, standby letters of credit, and

guarantees. This separate liability account for estimated

credit losses on off-balance sheet credit exposures should

not be reported as part of the ALLL on an institution’s

balance sheet. Loans and leases held for sale are carried on

the balance sheet at the lower of cost or fair value, with a

separate valuation allowance. This separate valuation

allowance should not be included as part of the ALLL and

accordingly regulatory capital.

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 charge-offs 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

LOANS Section 3.2

RMS Manual of Examination Policies 3.2-7 Loans (07-24)

Federal Deposit Insurance Corporation

the ALLL) set forth in generally accepted accounting

principles (U.S. 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 charge-off levels for similar loans, adjusted for

changes in current conditions or other relevant factors.

Calculation of historical charge-off rates can range from a

simple average of net charge-offs 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.

Responsibility of the Board and Management

It is the responsibility of the board of directors and

management to maintain the ALLL at an appropriate level.

The allowance should be evaluated, and appropriate

provisions made, at least quarterly. In carrying out their

responsibilities, the board and management are expected to:

• Establish and maintain a loan review system that

identifies, monitors, and addresses asset quality

problems in a timely manner.

• Ensure the prompt charge-off of loans, or portions of

loans, deemed uncollectible.

• Ensure that the process for determining an appropriate

allowance level is based on comprehensive,

adequately documented, and consistently applied

analysis.

For purposes of Reports of Condition and Income (Call

Reports) an appropriate ALLL for loans held for investment

should consist of the following items:

• The amount of allowance related to loans individually

evaluated and determined to be impaired under ASC

(Accounting Standards Codification) Subtopic 310-10,

Receivables - Overall.

• T

he amount of allowance related to loans that were

individually evaluated for impairment and determined

not to be impaired, as well as other loans collectively

evaluated under ASC Subtopic 450-20, Contingencies

– Loss Contingencies.

• T

he amount of allowance related to loans evaluated

under ASC Subtopic 310-30, Receivables –Loans and

Debt Securities Acquired with Deteriorated Credit

Quality.

• The amount of allowance related to international

transfer risk associated with its cross-border lending

exposure.

Furthermore, management’s analysis of an appropriate

allowance level requires significant judgement in

determining estimates of credit losses. An institution may

support its estimate through qualitative factors that adjust

historical loss rates or an unallocated portion that can be

supported through a similar analysis.

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. Examiners should

refer to ASC Subtopic 310-10 for guidance in establishing

an allowance for individually evaluated loans determined to

be impaired and measured under that standard. When

analyzing the appropriateness of an allowance, portfolios

evaluated collectively should group loans with similar

characteristics, such as risk classification, past due status,

type of loan, industry, or collateral. A depository institution

may, for example, analyze the following groups of loans and

provide for them in the ALLL:

• Significant credits reviewed on an individual basis

(i.e., impaired loans);

• Loans and leases that are not reviewed individually,

but which present elevated risk characteristics, such as

delinquency, adverse classification, or Special

Mention designation;

• Homogenous loans that are not reviewed individually,

and do not present elevated risk characteristics; and

• All other loans that have not been considered or

provided for elsewhere.

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

appropriate to absorb estimated losses from transfer risk

associated with its cross-border lending exposure.

Factors to Consider in Estimating Credit Losses

Estimated credit losses should reflect consideration of all

significant factors that affect the portfolio’s collectibility 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 appropriate ALLL level.

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Management should also consider any relevant qualitative

factors that are likely to cause estimated losses to differ from

historical loss experience such as:

• Changes in lending policies and procedures, including

underwriting, collection, charge-off and recovery

practices;

• Changes in local and national economic and business

conditions;

• Changes in the volume or type of credit extended;

• Changes in the experience, ability, and depth of

lending management;

• Changes in the volume and severity of past due,

nonaccrual, troubled debt restructurings, or classified

loans;

• Changes in the quality of an institution’s loan review

system or the degree of oversight by the board of

directors; and

• The existence of, or changes in the level of, any

concentrations of credit.

Institutions are also encouraged to use ratio analysis as a

supplemental check for evaluating the overall

reasonableness of an ALLL. 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 charge-off 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 appropriate ALLL. Such comparisons

do not eliminate the need for a comprehensive analysis and

documentation of the loan and lease portfolio and the factors

affecting its collectibility.

Examiner Responsibilities

Generally, following the quality assessment of the loan and

lease portfolio, the loan review system, and the lending

policies, examiners are responsible for assessing the

appropriateness of the ALLL. Examiners should consider

all significant factors that affect the collectibility of the

portfolio. Examination procedures for reviewing the

appropriateness of the ALLL are included in the

Examination Documentation (ED) Modules.

In assessing the overall appropriateness 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 should

improve over time. Therefore, examiners will generally

accept management’s estimates of credit losses in their

assessment of the overall appropriateness of the ALLL

when management has:

• Maintained effective systems and controls for

identifying, monitoring and addressing asset quality

problems in a timely manner;

• Analyzed all significant factors that affect the

collectibility of the portfolio; and

• Established an acceptable ALLL evaluation process

that meets the objectives for an appropriate ALLL.

If, after the completion of all aspects of the ALLL review

described in this section, the examiner does not concur that

the reported ALLL level is appropriate, 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.

Regulatory Reporting of the ALLL

An ALLL established in accordance with the guidelines

provided above should fall within a range of acceptable

estimates. When an ALLL is not deemed at an appropriate

level, management will be required to increase the provision

for loan and lease loss expense sufficiently to restore the

ALLL reported in its Call Report to an appropriate level.

Accounting and Reporting Treatment

ASC Subtopic 450-20 provides the basic guidance for

recognition of a loss from a contingency that should be

accrued through a charge to income (i.e., a provision

expense) when available information indicates that it is

probable the asset has been impaired and the amount is

reasonably estimated. ASC Subtopic 310-10 provides

specific guidance about the measurement and disclosure for

loans individually evaluated and determined to be impaired.

Loans are considered to be impaired when, based on current

information and events, it is probable that the creditor will

be unable to collect all interest and principal payments due

according to the contractual terms of the loan agreement.

This would generally include all loans restructured as a

troubled debt and nonaccrual loans.

For individually impaired loans, ASC Subtopic 310-10

provides guidance on the acceptable methods to measure

impairment. Specifically, this standard states that when a

loan is impaired, a creditor should measure impairment

based on the present value of expected future cash flows

discounted at the loan’s effective interest rate, except that as

a practical expedient, a creditor may measure impairment

based on a loan’s observable market price. However, the

Call Report instructions require an institution to use the fair

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value of the collateral in its determination of impairment for

all impaired collateral dependent loans. When developing

the estimate of expected future cash flows for a loan, an

institution should consider all available information

reflecting past events and current conditions, including the

effect of existing qualitative factors.

Large groups of smaller-balance homogenous loans are not

included in the scope of ASC Subtopic 310-10, unless the

loan is a troubled debt restructuring. Such groups of loans

may include, but are not limited to, credit card, residential

mortgage, and consumer installment loans. Examiners

should refer to ASC Subtopic 450-20 for loans collectively

evaluated for impairment, as well as individual loans that

are identified for evaluation on an individual basis and

determined not to be impaired.

Institutions should not layer their loan loss allowances.

Layering is the inappropriate practice of recording estimates

in the ALLL for the same loan under the different

accounting standards. Layering can happen when an

institution measures impairment on an individually

impaired loan and includes that same loan in its estimate of

loan losses on a collective basis, thereby estimating the loan

loss for the same loan twice.

While different institutions may use different methods,

there are certain common elements that should be included

in any ALLL methodology. Generally, an institution’s

methodology should:

• Include a detailed loan portfolio analysis, performed

regularly;

• Consider all loans (whether on an individual or group

basis);

• Identify loans to be evaluated for impairment on an

individual basis under ASC Subtopic 310-10; loans

evaluated under ASC Subtopic 310-30; and segment

the remainder of the portfolio into groups of loans

with similar risk characteristics for evaluation and

analysis under ASC Subtopic 450-20;

• Consider all known relevant internal and external

factors that may affect loan collectibility;

• Be applied consistently but, when appropriate, be

modified for new factors affecting collectibility;

• Consider the particular risks inherent in different

kinds of lending;

• Consider current collateral values (less costs to sell),

where applicable;

• Require that analyses, estimates, reviews and other

ALLL methodology functions be performed by

competent and well-trained personnel;

• Be based on current and reliable data;

• Be well-documented, in writing, with clear

explanations of the supporting analyses and rationale;

and

• Include a systematic and logical method to consolidate

the loss estimates and ensure the ALLL balance is

recorded in accordance with U.S. GAAP.

A systematic methodology that is properly designed and

implemented should result in an institution’s best estimate

of the ALLL. Accordingly, institutions should adjust their

ALLL balance, either upward or downward, in each period

for differences between the results of the systematic

determination process and the unadjusted ALLL balance in

the general ledger.

Examiners are encouraged, with the acknowledgement of

management, to communicate with an institution’s external

auditors and request an explanation of their rationale and

findings, when differences in judgment concerning the

appropriateness of the institution's ALLL exist. In case of

controversy, an institution and its auditor may be reminded

when an institution's supervisory agency's interpretation on

how U.S. GAAP should be applied to a specified event or

transaction (or series of related events or transactions)

differs from the institution's interpretation, the supervisory

agency may require the institution to reflect the event(s) or

transaction(s) in its Call Report in accordance with the

agency's interpretation and to amend previously submitted

reports.

Additional information on the documentation of the ALLL,

including its methodology, and the establishment of loan

review systems is provided in the Interagency Statement of

Policy on the Allowance for Loan and Lease Losses,

(including frequently asked questions) dated December 13,

2006, and the Interagency Policy Statement on Allowance

for Loan and Lease Losses Methodologies and

Documentation for Banks and Savings Associations, dated

July 2, 2001.

←

PORTFOLIO COMPOSITION

Commercial Loans

General

Loans to business enterprises for commercial or industrial

purposes, whether proprietorships, partnerships or

corporations, are commonly described as commercial loans.

In asset distribution, commercial or business loans

frequently comprise one of the most important assets of an

institution. They may be secured or unsecured and have

short or long-term maturities. Such loans include working

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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.

Commercial lending policies generally address 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

Accounts receivable financing is a specialized area of

commercial 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 institution'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.

Institutions use two basic methods to make accounts

receivable advances. First, blanket assignment, wherein the

borrower periodically informs the institution of the amount

of receivables outstanding on its books. Based on this

information, the institution 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 institution. The institution 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 institution advances the agreed

percentage of the outstanding receivables. The receivables

are usually pledged on a notification basis. Under this

method, the institution maintains complete control of the

funds paid on all accounts pledged by requiring the

borrower's customer to remit directly to the institution.

In the area of accounts receivable financing, an institution's

lending policy typically addresses the acquisition of credit

information such as property, operating and cash flow

statements. It also typically addresses 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.

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Leveraged Lending

The federal institution regulatory agencies initially issued

guidance on April 9, 2001, concerning sound risk

management practices for institutions engaged in leveraged

financing. In light of the developments and experience

gained since the initial guidance was issued, the federal

institution regulatory agencies issued new Interagency

Guidance on Leveraged Lending on May 21, 2013, to

update and replace the 2001 guidance. Examiners should

also review the related Frequently Asked Questions (FAQ)

issued on November 7, 2014.

Applicability

A financial institution’s risk management practices should

be consistent with the size and risk profile of its leveraged

activities relative to its assets, earnings, liquidity, and

capital. Institutions that originate or sponsor leveraged

transactions can refer to the guidance for suggestions about

sound risk management principles.

The agencies do not intend for a financial institution that

originates a small number of less complex, leveraged loans

to have policies and procedures commensurate with a larger,

more complex leveraged loan origination business.

However, any financial institution that participates in

leveraged lending transactions may refer to and consider

supervisory guidance provided in the “Participations

Purchased” section of the guidance.

General

Leveraged lending is an important type of financing for

national and global economies, and the U.S. financial

industry plays an integral role in making credit available and

syndicating that credit to investors. In particular, financial

institutions should ensure they do not unnecessarily

heighten risks by originating poorly underwritten loans. For

example, a poorly underwritten leveraged loan that is

pooled with other loans or is participated with other

institutions may generate risks for the financial system.

Numerous definitions of leveraged lending exist throughout

the financial services industry and commonly contain some

combination of the following:

• Proceeds used for buyouts, acquisitions, or capital

distributions.

• Transactions where the borrower’s Total Debt divided

by EBITDA (earnings before interest, taxes,

depreciation, and amortization) or Senior Debt divided

by EBITDA exceed 4.0X EBITDA or 3.0X EBITDA,

respectively, or other defined levels appropriate to the

industry or sector.

• A borrower recognized in the debt markets as a highly

leveraged firm, which is characterized by a high debt-

to-net-worth ratio.

• Transactions when the borrower’s post-financing

leverage, as measured by its leverage ratios (for

example, debt-to-assets, debt-to-net-worth, debt-to-

cash flow, or other similar standards common to

particular industries or sectors), significantly exceeds

industry norms or historical levels.

A financial institution engaging in leveraged lending

typically defines the activity within its policies and

procedures in a manner sufficiently detailed to ensure

consistent application across all business lines. An

appropriate definition describes clearly the purposes and

financial characteristics common to these transactions, and

covers risk from both direct exposure and indirect exposure

via limited recourse financing secured by leveraged loans,

or financing extended to financial intermediaries (such as

conduits and special purpose entities (SPEs)) that hold

leveraged loans.

In general, sound risk management of leveraged lending

activities places importance on institutions developing and

maintaining the following:

• Transactions structured to reflect a sound business

premise, an appropriate capital structure, and

reasonable cash flow and balance sheet leverage.

Combined with supportable performance projections,

these elements of a safe-and-sound loan structure

should clearly support a borrower’s capacity to repay

and to de-lever to a sustainable level over a reasonable

period, whether underwritten to hold or distribute;

• A definition of leveraged lending that facilitates

consistent application across all business lines;

• Well-defined underwriting standards that, among

other things, define acceptable leverage levels and

describe amortization expectations for senior and

subordinate debt;

• A credit limit and concentration framework consistent

with the institution’s risk appetite;

• Sound Management Information Systems (MIS) that

enable management to identify, aggregate, and

monitor leveraged exposures and comply with policy

across all business lines;

• Strong pipeline management policies and procedures

that, among other things, provide for real-time

information on exposures and limits, and exceptions to

the timing of expected distributions and approved hold

levels; and

• Guidelines for conducting periodic portfolio and

pipeline stress tests to quantify the potential impact of

economic and market conditions on the institution’s

asset quality, earnings, liquidity, and capital.

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Risk Management Framework

Given the high-risk profile of leveraged transactions,

prudent financial institutions engaged in leveraged lending

adopt a risk management framework that has an intensive

and frequent review and monitoring process. The

framework has as its foundation written risk objectives, risk

acceptance criteria, and risk controls. A lack of robust risk

management processes and controls at a financial institution

with significant leveraged lending activities could

contribute to supervisory findings that the financial

institution is engaged in unsafe-and-unsound banking

practices.

General Policies

A financial institution’s credit policies and procedures for

leveraged lending generally address the following:

• Identification of the financial institution’s risk appetite

including clearly defined amounts of leveraged

lending that the institution is willing to underwrite (for

example, pipeline limits) and is willing to retain (for

example, transaction and aggregate hold levels). The

designated risk appetite is commonly supported by an

analysis of the potential effect on earnings, capital,

liquidity, and other risks that result from these

positions, and is approved by the board of directors;

• A limit framework that includes limits or guidelines

for single obligors and transactions, aggregate hold

portfolio, aggregate pipeline exposure, and industry

and geographic concentrations. This limit framework

identifies the related management approval authorities

and exception tracking provisions. In addition to

notional pipeline limits, financial institutions with

significant leveraged transactions implement

underwriting limit frameworks that assess stress

losses, flex terms, economic capital usage, and

earnings at risk or that otherwise provide a more

nuanced view of potential risk;

• Procedures for ensuring the risks of leveraged lending

activities are appropriately reflected in an institution’s

allowance for loan and lease losses (ALLL) and

capital adequacy analyses;

• Credit and underwriting approval authorities,

including the procedures for approving and

documenting changes to approved transaction

structures and terms;

• Guidelines for appropriate oversight by senior

management, including adequate and timely reporting

to the board of directors;

• Expected risk-adjusted returns for leveraged

transactions;

• Minimum underwriting standards (see “Underwriting

Standards” section below); and,

• Effective underwriting practices for primary loan

origination and secondary loan acquisition.

Participations Purchased

Well-managed financial institutions purchasing

participations and assignments in leveraged lending

transactions make a thorough, independent evaluation of the

transaction and the risks involved before committing any

funds. They should apply the same standards of prudence,

credit assessment and approval criteria, and in-house limits

that would be employed if the purchasing organization were

originating the loan. Policies typically include requirements

for:

• Obtaining and independently analyzing full credit

information both before the participation is purchased

and on a timely basis thereafter;

• Obtaining from the lead lender copies of all executed

and proposed loan documents, legal opinions, title

insurance policies, Uniform Commercial Code (UCC)

searches, and other relevant documents;

• Carefully monitoring the borrower’s performance

throughout the life of the loan; and

• Establishing appropriate risk management guidelines

as described in this document.

Underwriting Standards

A financial institution’s underwriting standards should be

clear, written and measurable, and should accurately reflect

the institution’s risk appetite for leveraged lending

transactions. Examiners should review whether a financial

institution has clear underwriting limits regarding leveraged

transactions, including the size that the institution will

arrange both individually and in the aggregate for

distribution. Legal and other risks associated with poorly

underwritten transactions may find their way into a wide

variety of investment instruments and exacerbate systemic

risks within the general economy. An institution’s

underwriting standards typically consider the following:

• Whether the business premise for each transaction is

sound and the borrower’s capital structure is

sustainable regardless of whether the transaction is

underwritten for the institution’s own portfolio or with

the intent to distribute.

• A borrower’s capacity to repay and ability to de-lever

to a sustainable level over a reasonable period.

• Expectations for the depth and breadth of due

diligence on leveraged transactions.

• Standards for evaluating expected risk-adjusted

returns.

• The degree of reliance on enterprise value and other

intangible assets for loan repayment, along with

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acceptable valuation methodologies, and guidelines

for the frequency of periodic reviews of those values;

• Expectations for the degree of support provided by the

sponsor (if any), taking into consideration the

sponsor’s financial capacity, the extent of its capital

contribution at inception, and other motivating factors.

• Whether credit agreement terms allow for the material

dilution, sale, or exchange of collateral or cash flow-

producing assets without lender approval;

• Credit agreement covenant protections, including

financial performance (such as debt-to-cash flow,

interest coverage, or fixed charge coverage), reporting

requirements, and compliance monitoring.

• Collateral requirements in credit agreements that

specify acceptable collateral and risk-appropriate

measures and controls, including acceptable collateral

types, loan-to-value guidelines, and appropriate

collateral valuation methodologies. Standards for

asset-based loans that are part of the entire debt

structure outline expectations for the use of collateral

controls (for example, inspections, independent

valuations, and payment lockbox), other types of

collateral and account maintenance agreements, and

periodic reporting requirements; and

• Whether loan agreements provide for distribution of

ongoing financial and other relevant credit

information to all participants and investors.

Credit Analysis

Effective underwriting and management of leveraged

lending risk is highly dependent on the quality of analysis

employed during the approval process as well as ongoing

monitoring. An institution’s analysis of leveraged lending

transactions typically ensures that:

• Cash flow analyses do not rely on overly optimistic or

unsubstantiated projections of sales, margins, and

merger and acquisition synergies;

• Liquidity analyses include performance metrics

appropriate for the borrower’s industry; predictability

of the borrower’s cash flow; measurement of the

borrower’s operating cash needs; and ability to meet

debt maturities;

• Projections exhibit an adequate margin for

unanticipated merger-related integration costs;

• Projections are stress tested for one or two downside

scenarios, including a covenant breach;

• Transactions are reviewed at least quarterly to

determine variance from plan, the related risk

implications, and the accuracy of risk ratings and

accrual status;

• Enterprise and collateral valuations are independently

derived or validated outside of the origination

function, are timely, and consider potential value

erosion;

• Collateral liquidation and asset sale estimates are

based on current market conditions and trends;

• Potential collateral shortfalls are identified and

factored into risk rating and accrual decisions;

• Contingency plans anticipate changing conditions in

debt or equity markets when exposures rely on

refinancing or the issuance of new equity; and

• The borrower is adequately protected from interest

rate and foreign exchange risk.

Valuation Standards

Institutions often rely on enterprise value and other

intangibles when (1) evaluating the feasibility of a loan

request; (2) determining the debt reduction potential of

planned asset sales; (3) assessing a borrower’s ability to

access the capital markets; and, (4) estimating the strength

of a secondary source of repayment. Institutions may also

view enterprise value as a useful benchmark for assessing a

sponsor’s economic incentive to provide financial support.

Given the specialized knowledge needed for the

development of a credible enterprise valuation and the

importance of enterprise valuations in the underwriting and

ongoing risk assessment processes, enterprise valuations

should be performed by qualified persons independent of an

institution’s origination function.

There are several methods used for valuing businesses. The

most common valuation methods are assets, income, and

market. Asset valuation methods consider an enterprise’s

underlying assets in terms of its net going-concern or

liquidation value. Income valuation methods consider an

enterprise’s ongoing cash flows or earnings and apply

appropriate capitalization or discounting techniques.

Market valuation methods derive value multiples from

comparable company data or sales transactions. However,

final value estimates should be based on the method or

methods that give supportable and credible results. In many

cases, the income method is generally considered the most

reliable.

There are two common approaches employed when using

the income method. The “capitalized cash flow” method

determines the value of a company as the present value of

all future cash flows the business can generate in perpetuity.

An appropriate cash flow is determined and then divided by

a risk-adjusted capitalization rate, most commonly the

weighted average cost of capital. This method is most

appropriate when cash flows are predictable and stable. The

“discounted cash flow” method is a multiple-period

valuation model that converts a future series of cash flows

into current value by discounting those cash flows at a rate

of return (referred to as the “discount rate”) that reflects the

risk inherent therein. This method is most appropriate when

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future cash flows are cyclical or variable over time. Both

income methods involve numerous assumptions, and

therefore, supporting documentation should fully explain

the evaluator’s reasoning and conclusions.

When a borrower is experiencing a financial downturn or

facing adverse market conditions, a prudent lender will

reflect those adverse conditions in its assumptions for key

variables such as cash flow, earnings, and sales multiples

when assessing enterprise value as a potential source of

repayment. Changes in the value of a borrower’s assets are

typically tested under a range of stress scenarios, including

business conditions more adverse than the base case

scenario. Stress tests of enterprise values and their

underlying assumptions are generally conducted and

documented at origination of the transaction and

periodically thereafter, incorporating the actual

performance of the borrower and any adjustments to

projections. Prudent institutions perform their own

discounted cash flow analysis to validate the enterprise

value implied by proxy measures such as multiples of cash

flow, earnings, or sales.

Enterprise value estimates derived from even the most

rigorous procedures are imprecise and ultimately may not

be realized. Therefore, institutions relying on enterprise

value or illiquid and hard-to-value collateral typically have

policies that provide for appropriate loan-to-value ratios,

discount rates, and collateral margins. Based on the nature

of an institution’s leveraged lending activities, the prudent

institution establishes limits for the proportion of individual

transactions and the total portfolio that are supported by

enterprise value. Regardless of the methodology used, the

assumptions underlying enterprise-value estimates typically

are clearly documented, well supported, and understood by

the institution’s appropriate decision-makers and risk

oversight units. Further, an institution’s valuation methods

are appropriate for the borrower’s industry and condition.

Risk Rating Leveraged Loans

The risk rating of leveraged loans involves the use of

realistic repayment assumptions to determine a borrower’s

ability to de-lever to a sustainable level within a reasonable

period of time. For example, supervisors commonly assume

that the ability to fully amortize senior secured debt or the

ability to repay at least 50 percent of total debt over a five-

to-seven year period provides evidence of adequate

repayment capacity. If the projected capacity to pay down

debt from cash flow is nominal with refinancing the only

viable option, the credit will usually be adversely rated even

if it has been recently underwritten. In cases when

leveraged loan transactions have no reasonable or realistic

prospects to de-lever, a Substandard rating is likely.

Furthermore, when assessing debt service capacity,

extensions and restructures should be scrutinized to ensure

that the institution is not merely masking repayment

capacity problems by extending or restructuring the loan.

If the primary source of repayment becomes inadequate, it

would generally be inappropriate for an institution to

consider enterprise value as a secondary source of

repayment unless that value is well supported. Evidence of

well-supported value may include binding purchase and sale

agreements with qualified third parties or thorough asset

valuations that fully consider the effect of the borrower’s

distressed circumstances and potential changes in business

and market conditions. For such borrowers, when a portion

of the loan may not be protected by pledged assets or a well-

supported enterprise value, examiners generally will rate

that portion Doubtful or Loss and place the loan on

nonaccrual status.

Risks in leveraged lending activities are considered in the

ALLL and capital adequacy analysis. For allowance

purposes, leverage exposures are typically taken into

account either through analysis of the estimated credit

losses from the discrete portfolio or as part of an overall

analysis of the portfolio utilizing the institution's internal

risk grades or other factors. At the transaction level,

exposures heavily reliant on enterprise value as a secondary

source of repayment are typically scrutinized to determine

the need for and adequacy of specific allocations.

Problem Credit Management

Individual action plans are typically formulated by

management when working with borrowers experiencing

diminished operating cash flows, depreciated collateral

values, or other significant plan variances. Weak initial

underwriting of transactions, coupled with poor structure

and limited covenants, may make problem credit

discussions and eventual restructurings more difficult for an

institution as well as result in less favorable outcomes.

A financial institution generally formulates credit policies

that define expectations for the management of adversely

rated and other high-risk borrowers whose performance

departs significantly from planned cash flows, asset sales,

collateral values, or other important targets. These policies

typically stress the need for workout plans that contain

quantifiable objectives and measureable time frames.

Actions may include working with the borrower for an

orderly resolution while preserving the institution’s

interests, sale of the credit in the secondary market, or

liquidation of collateral. Problem credits should be

reviewed regularly for risk rating accuracy, accrual status,

recognition of impairment through specific allocations, and

charge-offs.

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Reporting and Analytics

Diligent financial institutions regularly monitor higher risk

credits, including leveraged loans. Monitoring includes

management’s review of comprehensive reports about the

characteristics and trends in such exposures at least

quarterly, with summaries provided to the board of

directors. Policies and procedures typically identify the

fields to be populated and captured by a financial

institution’s MIS, which then yields accurate and timely

reporting to management and the board of directors that may

include the following:

• Individual and portfolio exposures within and across

all business lines and legal vehicles, including the

pipeline;

• Risk rating distribution and migration analysis,

including maintenance of a list of those borrowers

who have been removed from the leveraged portfolio

due to improvements in their financial characteristics

and overall risk profile;

• Industry mix and maturity profile;

• Metrics derived from probabilities of default and loss

given default;

• Portfolio performance measures, including

noncompliance with covenants, restructurings,

delinquencies, non-performing amounts, and charge-

offs;

• Amount of impaired assets and the nature of

impairment, and the amount of the ALLL attributable

to leveraged lending;

• The aggregate level of policy exceptions and the

performance of that portfolio;

• Exposures by collateral type, including unsecured

transactions and those where enterprise value will be

the source of repayment for leveraged loans.

Reporting also typically considers the implications of

defaults that trigger pari-passu treatment for all

lenders and, thus, dilute the secondary support from

the sale of collateral;

• Secondary market pricing data and trading volume,

when available;

• Exposures and performance by deal sponsors. Deals

introduced by sponsors may, in some cases, be

considered exposure to related borrowers. An

institution should identify, aggregate, and monitor

potential related exposures;

• Gross and net exposures, hedge counterparty

concentrations, and policy exceptions;

• Actual versus projected distribution of the syndicated

pipeline, with regular reports of excess levels over the

hold targets for the syndication inventory. Well-

designed pipeline definitions clearly identify the type

of exposure. This includes committed exposures that

have not been accepted by the borrower, commitments

accepted but not closed, and funded and unfunded

commitments that have closed but have not been

distributed; and

• Total and segmented leveraged lending exposures,

including subordinated debt and equity holdings,

alongside established limits. Reports typically

provide a detailed and comprehensive view of global

exposures, including situations when an institution has

indirect exposure to an obligor or is holding a

previously sold position as collateral or as a reference

asset in a derivative.

Borrower and counterparty leveraged lending reporting

typically consider exposures booked in other business units

throughout the institution, including indirect exposures such

as default swaps and total return swaps, naming the

distributed paper as a covered or referenced asset or

collateral exposure through repo transactions. Additionally,

the positions in the held for sale or traded portfolios or

through structured investment vehicles owned or sponsored

by the originating institution or its subsidiaries or affiliates

are typically considered.

Deal Sponsors

A financial institution that relies on sponsor support as a

secondary source of repayment typically develops

guidelines for evaluating the qualifications of financial

sponsors and implements processes to regularly monitor a

sponsor’s financial condition. Deal sponsors may provide

valuable support to borrowers such as strategic planning,

management, and other tangible and intangible benefits.

Sponsors may also provide sources of financial support for

borrowers that fail to achieve projections. Generally, a

financial institution rates a borrower based on an analysis of

the borrower’s standalone financial condition. However, a

financial institution may consider support from a sponsor in

assigning internal risk ratings when the institution can

document the sponsor’s history of demonstrated support as

well as the economic incentive, capacity, and stated intent

to continue to support the transaction. However, even with

documented capacity and a history of support, the sponsor’s

potential contributions may not mitigate supervisory

concerns absent a documented commitment of continued

support. An evaluation of a sponsor’s financial support

typically includes the following:

• The sponsor’s historical performance in supporting its

investments, financially and otherwise;

• The sponsor’s economic incentive to support,

including the nature and amount of capital contributed

at inception;

• Documentation of degree of support (for example, a

guarantee, comfort letter, or verbal assurance);

• Consideration of the sponsor’s contractual investment

limitations;

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• To the extent feasible, a periodic review of the

sponsor’s financial statements and trends, and an

analysis of its liquidity, including the ability to fund

multiple deals;

• Consideration of the sponsor’s dividend and capital

contribution practices;

• The likelihood of the sponsor supporting a particular

borrower compared to other deals in the sponsor’s

portfolio; and,

• Guidelines for evaluating the qualifications of a

sponsor and a process to regularly monitor the

sponsor’s performance.

Independent Credit Review

A financial institution with a strong and independent credit

review function demonstrates the ability to identify

portfolio risks and documented authority to escalate

inappropriate risks and other findings to their senior

management. Due to the elevated risks inherent in

leveraged lending, and depending on the relative size of a

financial institution’s leveraged lending business, there is

greater importance for the institution’s credit review

function to assess the performance of the leveraged

portfolio more frequently and in greater depth than other

segments in the loan portfolio. To be most effective, such

assessments are performed by individuals with the expertise

and experience for these types of loans and the borrower’s

industry. Portfolio reviews are generally conducted at least

annually. For many financial institutions, the risk

characteristics of leveraged portfolios, such as high reliance

on enterprise value, concentrations, adverse risk rating

trends, or portfolio performance, may dictate more frequent

reviews.

A financial institution that staffs its internal credit review

function appropriately and ensures that the function has

sufficient resources is most capable of providing timely,

independent, and accurate assessments of leveraged lending

transactions. Effective reviews evaluate the level of risk,

risk rating integrity, valuation methodologies, and the

quality of risk management. Such internal credit reviews

that review the institution’s leveraged lending practices,

policies, and procedures provide management with a

complete assessment of the leveraged lending program.

Stress Testing

A financial institution typically develops and implements

guidelines for conducting periodic portfolio stress tests on

loans originated to hold as well as loans originated to

distribute, and sensitivity analyses to quantify the potential

impact of changing economic and market conditions on its

asset quality, earnings, liquidity, and capital. The

sophistication of stress-testing practices and sensitivity

analyses are most effective when they are consistent with

the size, complexity, and risk characteristics of the

institution’s leveraged loan portfolio. To the extent a

financial institution is required to conduct enterprise-wide

stress tests, the leveraged portfolio should be included in

any such tests.

Conflicts of Interest

A financial institution typically develops appropriate

policies and procedures to address and to prevent potential

conflicts of interest when it has both equity and lending

positions. For example, an institution may be reluctant to

use an aggressive collection strategy with a problem

borrower because of the potential impact on the value of an

institution’s equity interest. A financial institution may

encounter pressure to provide financial or other privileged

client information that could benefit an affiliated equity

investor. Such conflicts also may occur when the

underwriting financial institution serves as financial advisor

to the seller and simultaneously offers financing to multiple

buyers (that is, stapled financing). Similarly, there may be

conflicting interests among the different lines of business

within a financial institution or between the financial

institution and its affiliates. When these situations occur,

potential conflicts of interest arise between the financial

institution and its customers. Effective policies and

procedures clearly define potential conflicts of interest,

identify appropriate risk management controls and

procedures, enable employees to report potential conflicts

of interest to management for action without fear of

retribution, and ensure compliance with applicable laws.

Further, an established training program for employees on

appropriate practices to follow to avoid conflicts of interest

is an effective risk management practice.

Oil and Gas Lending

Industry Overview

Oil and gas (O&G) lending is complex and highly

specialized due to factors such as global supply and

demand, geopolitical uncertainty, weather-related

disruptions, fluctuations and volatility in currency markets

(i.e. the strength of the U.S. dollar compared to global

currency markets), and changes in environmental and other

governmental policies. As such, companies and borrowers

that are directly or indirectly tied to the O&G industry

frequently experience expansion and contraction within key

operational areas of their businesses that will directly

impact their financial condition and repayment capacity.

The O&G industry has four interconnected segments:

• Upstream - exploration and production (E&P)

companies

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• Midstream - transporting, treating, processing, storing,

and marketing to Upstream companies

• Downstream - refining and marketing

• Support/Services - equipment, services, or support

activities (e.g. drilling, workover units, and water

hauling services)

O&G lending to Upstream companies for E&P activities is

a specialized form of lending, and is the primary focus of

this section (see Reserve-Based Lending below). Loans to

Midstream, Downstream and Support/Service companies

are generally structured similar to other commercial loans.

In addition, Midstream companies often raise capital

through Master Limited Partnerships that are publicly

traded. The highest credit risk is typically found in

Support/Services and Upstream lending, which are more

directly affected by changes in production and commodity

prices.

Reserve-Based Lending

Loans for E&P activities are typically secured by proved

reserves and governed by a borrowing base, an arrangement

known as reserve-based lending, or RBL. Effective credit

risk management in RBL requires conservative

underwriting, appropriate structuring, experienced and

knowledgeable lending staff, and sound loan administration

practices. It is also important for the board and senior

management to consider the unique risks associated with

this type of lending when developing RBL policies and

approving and administering such loans. These risks

include, but are not limited to, credit, concentration, market

volatility/pricing, limited purpose collateral, production,

operational, legal, compliance/environmental, interest rate,

liquidity, strategic, and third-party risk.

RBL may appear similar to traditional asset based lending

(ABL), but there are notable differences. The primary

source of repayment for ABL is the orderly liquidation of

the collateral (receivables and inventory) into cash. Such

loans are typically structured with strong controls over the

collateral, such as a lock box arrangement. In contrast, the

primary source of repayment for RBL is the cash flows

derived from the extraction of O&G reserves. An

independent, third-party reserve engineering report serves

as the primary underwriting tool to estimate the future cash

stream and establish a “borrowing base,” which is a

collateral base agreed to by the borrower and lender that is

used to limit the amount of funds the lender advances the

borrower. The borrowing base is subject to periodic

redeterminations, typically semiannually, that can result in

the reduction of the borrowing base commitment when

commodity prices and reserves are declining.

Types of Reserves

Lenders should generally only consider proved reserves,

defined as having at least a 90 percent probability that the

quantities actually recovered will equal or exceed the

estimate, in determining collateral value. Within the proved

reserves category, Proved Developed Producing (PDP),

Proved Developed Non-Producing (PDNP), and Proved

Undeveloped (PUD) reserves are collectively known as P1.

As described below, PDNP and PUD require capital

expenditures (CAPEX) to bring the non-producing and

undeveloped reserves online as PDP:

• PDP represents reserves that are recoverable from

existing wells with existing equipment and operating

methods that are producing at the time of the

engineering report estimate.

• PDNP reserves include both shut-in (PDSI) and

behind the pipe (PDBP) reserves, and production can

be initiated or restored with relatively low

expenditures compared to the cost of drilling a new

well.

o PDSI reserves are completion intervals that are

open, but have not started producing; were shut-in

for market conditions or pipeline connections; or

not capable of production for mechanical reasons.

o PDBP reserves are those expected to be recovered

from existing wells that require additional

completion work or future completion prior to the

start of production.

• PUD reserves are expected to be recovered only after

making future investment. These reserves have been

proved by independent engineering reports, but do not

have a well infrastructure in place.

Other categories of reserves include “probable” (P2) and

“possible” (P3). Probable reserves are relatively uncertain,

while possible reserves are considered speculative in nature.

Probable and possible reserves should not receive any value

when determining the borrowing base.

Reserve Engineering Reports

Reserve engineering reports are an estimate of the volumes

of O&G reserves that are likely to be recovered based on

reasonable assumptions regarding physical characteristics

of the reservoir, available technology, and operating

efficiencies. The significant reliance on engineering reports

in underwriting RBL facilities requires sound internal

controls over the collateral evaluation process. Reserve

reports must be objective; based on reasonable, well-

documented assumptions; and completed independently of

the loan origination and collection functions. It is important

for management to document the qualifications and

independence of the engineer, and to periodically evaluate

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the production performance, which includes a comparison

of production projections to actual results.

RBL collateral value consists of a point-in-time estimate of

the present value (PV) of future net revenue (FNR) derived

from the production and sale of existing O&G reserves, net

of operating expenses, production taxes, royalties, and

CAPEX, discounted at an appropriate rate. The engineering

reports should contain sufficient information and

documentation to support the assumptions and the analysis

used to derive the forecasted cash flows and discounted PV.

Well-managed banks provide clear guidance to the engineer

at engagement regarding discount rates, pricing

assumptions, operating expense escalation rates, and risk-

adjustment guidelines limiting higher risk reserves. The

engineer will conduct an analysis of production reports from

the subject properties, and project estimated reserve

depletion.

Borrowing Base

The collateral base securing each facility should be

primarily comprised of PDP reserves. Inclusion of PDNP

reserves in the collateral evaluation should be supported

with sufficient documentation to demonstrate that the

borrower has the financial capacity to convert PDNP

reserves to PDP reserves by making the necessary

investments to restore or initiate production within the near-

term.

To include PUDs in the borrowing base calculation, the

borrower should have sufficient liquidity and positive Free

Cash Flow to meet operational needs, and debt service

requirements, as well as be able to fund (or obtain the

funding for) the CAPEX that would be required to convert

these undeveloped reserves into production. Potential sale

and/or marketability of the PUDs can also be considered

when evaluating collateral values, provided there is

adequate documentation of recent PUD sales.

Lenders use risk-adjustment factors to lower the value of

unseasoned producing and non-producing reserves before

applying borrowing base advance rates. It is important to

consider policy limits on production vs. non-production

reserves, the oil and gas mix, maximum production coming

from one well (single well concentration risk), and other

risk-adjustment factors. Ideally, management achieves

diversification in the geographic location of reserve fields,

and establishes limits on the lowest number of producing

wells needed to establish an acceptable borrowing base.

Typically, the advance rate for high-quality proved (P1)

reserves rarely exceed 65 percent (a typical range is 50 to

65 percent) of the PV of FNR. If the lender determines that

PDNP or PUD reserves are to be considered in the

borrowing base, these reserves should generally not exceed

25 to 35 percent of the total borrowing base. In addition,

PDNP and PUD reserves should be risk-adjusted (65 to 75

percent for PDNP and 25 to 50 percent for PUD, for

example) prior to applying the advance rate. Lenders may

apply separate risk-adjusted advance rates for each proved

reserve category in the borrowing base. During extended

periods of low or declining commodity prices, it is not

uncommon for banks to increase the risk adjustment for

PDNP and PUD reserves.

As part of the underwriting process, lending personnel

typically prepare both base-case and sensitivity-case

analyses that focus on the ability of converting the

underlying collateral into cash to repay the loan, including

an estimate of the impact that sustained adverse changes in

market conditions would have on a company’s repayment

ability. A base-case analysis uses standard assumption

scenarios and generally includes a discount to current prices

against the forward curve (projected futures pricing

estimates of the commodity). A sensitivity case analysis

subjects the O&G reserves to adverse external factors such

as lower market prices and/or higher operating expenses to

ascertain the effect on loan repayment. Full debt service

capacity (DSC) is typically analyzed using both the base-

case and sensitivity-case scenarios.

Discount Rates

The Securities and Exchange Commission (SEC) requires

publicly traded companies to report the value of their

reserves using a standard discount rate of 10 percent in

accordance with ASC Topic 932, Extractive Activities - Oil

and Gas. In evaluating collateral valuations for RBL

facilities, banks often utilize alternative discount rates. For

creditworthy borrowers and during more benign operating

cycles, a 9 percent discount rate is commonly used. For

higher-risk borrowers or during volatile or declining market

cycles for O&G, higher discount rates are typically used. If

a discount rate is selected that significantly differs from

generally accepted discount rates, examiners should assess

management’s documentation supporting its rationale.

Some banks may use multiple discount rates under certain

circumstances. An example may include establishing a

standard discount rate for performing credits and a higher

rate for higher risk facilities.

Price Decks

Prudent management regularly evaluates, and updates as

necessary, its pricing assumptions for RBL, commonly

referred to as the institution’s price deck. The price deck is

a forecast used to derive cash flow and collateral value

assumptions, and typically is approved by the board of

directors or a specifically designated board committee.

Pricing assumptions typically represent the most significant

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variable in driving the final estimate of value, and must be

well-supported.

Each institution’s price deck typically reflects both base-

case and sensitivity-case pricing scenarios. Pricing

assumptions for the sensitivity case are generally

sufficiently conservative and used to determine whether the

borrower has the financial capacity to generate adequate

cash flow to repay the debt during a prolonged low

commodity price environment. Price deck considerations

include, for example, current commodity pricing, forward

curve projections (future price considerations), cost

assumptions, discount rates, and timing of the various

reports. Management also typically documents any risk-

based adjustments applied to each proved reserve category.

While the risk-adjusted base case projections will generally

be used to underwrite RBLs, consideration is also given to

the ability to repay the debt using the risk-adjusted

sensitivity case to determine potential exposure due to

adverse market price fluctuations.

Loan Structure

RBL credit facilities are typically structured as a revolving

line of credit (RLOC), a reducing revolving line of credit

(RRLOC), or an amortizing term loan, governed by a well-

supported and fully documented borrowing base. These

credit facilities generally fully amortize within the half-life

of the reserves (that is, the time in years required to produce

one-half of the total estimated recoverable production) with

repayment aligning with projected cash flows. In other

words, the term of the loans should be tied to the economic

life of the underlying asset. This is often represented as the

“reserve tail tests” that are based on the economic half-life

of the reserves or the cash flow remaining after projected

loan payout.

Loan durations should be fairly short-term and directly tied

to the economic life of the asset (generally 50 to 60 percent

of the economic life of the proved reserves or the proved

reserves’ half-life). The terms generally depend on the

projected and actual reserve production (reserve run data),

as well as the type and range of collateral (PDP, PDNP, or

PUD). A reasonable portion of the estimated revenues

should remain after the debt has fully amortized (reserve

tail). Borrowing bases should be re-determined at least

semiannually, subject to an updated reserve engineering

report.

Covenants

Appropriate use of covenants is imperative in managing

credit risk for O&G loans. Lenders typically require

financial covenants to instill discipline in the lending

relationship, including the borrower’s leverage position,

repayment capacity, and liquidity. In addition, well-

designed covenants limit cash distributions to

owners/shareholders, and include standard performance and

financial reporting requirements. Examples of commonly

used ratios/covenants for evaluating E&P companies

include Free Cash Flow (FCF), Interest Coverage, Fixed

Charge Coverage, Current Ratio, Quick Ratio, Senior

Debt/EBITDA(X), and Total Debt/EBITDA(X). The

calculation of earnings before interest, taxes, depreciation,

and amortization (EBITDA) typically incorporates

maintenance CAPEX (X) due to its impact on the amount

of projected FCF that is available after debt service to

support operations.

Hedging

When used properly, hedging may be an effective tool to

help protect the borrower and the lender from sharp

commodity price declines by providing a stable cash flow

stream. E&P companies frequently use hedging

instruments such as futures contracts, swaps, collars, and

put options to reduce price risk exposure. Generally, hedges

should be limited to no more than 85 percent of projected

production volumes. Counterparties are typically limited to

reputable, financially sound companies that are approved in

accordance with the institution’s O&G loan policy. If the

hedges are taken as collateral or part of the borrowing base,

the advance rate and any limitations on the hedging position

should be documented in the loan agreement. If hedges are

sold or monetized, the proceeds of such are generally

applied to the respective debt.

Borrower and Financial Analysis

Management should have a clear understanding of the

overall financial health of the borrower that includes an

assessment of the borrower’s ability to maintain operations

through adverse market conditions. E&P companies in

sound financial condition should have strong cash flow

from reliable revenue sources and well-controlled operating

expenses. Companies should also have adequate sources of

liquidity and effective working capital management, sound

reserve development practices, well-defined criteria for

divestiture, adequate capital structure, manageable levels of

debt, and appropriate financial reporting. As part of the

overall financial analysis of the relationship, updated

engineering data should be well-documented and should

enable the lender to determine the borrower’s capacity to

service the debt. Any over-advance situation should have a

reasonable plan and timeframe to cure the over-advance.

The principals of successful E&P companies should be

experienced and have a well-documented track record of

managing through all stages of the business cycle. In good

times, company management should be able to identify,

acquire, and develop reserves profitably and in line with

expectations. During declining price cycles, company

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management should be able to demonstrate the ability to

streamline operations, maintain reasonable production,

manage working capital, strategically reduce CAPEX, and

make sound divestitures to ensure repayment of debt. Bank

management should evaluate the borrower’s cost cycle,

which reflects not only the ability to generate cash flow

from production, but also the CAPEX necessary to replace

depleted reserves. Working capital management is

critically important, as delinquent payments to vendors can

result in a negative working capital position (due to

accounts payable increasing) and an increased leverage

ratio.

Financial analysis typically includes the following:

• Adequacy of operating cash flows to service existing

total debt;

• Overall compliance with financial covenants,

including borrowing base limitations as detailed in the

loan agreement;

• Reasonableness of the company’s budget assumptions

and projections;

• Comparison of borrower provided production

projections with actual results;

• Working capital, tangible net worth, and leverage

positions; and

• Impact of capital expenses and recent acquisitions.

O&G Loan Policy Guidelines

The O&G loan policy should provide sufficient guidance to

loan officers, clearly convey appropriate policy limitations

and monitoring procedures, and detail appropriate

underwriting standards and practices. The O&G policy

should clearly indicate those industry segments (Upstream,

Midstream, Downstream, and Support/Services) the board

chooses to lend to and include guidance on each of those

segments.

For institutions engaged in RBL, appropriate policies

address reserve measurement and valuation analysis,

borrowing base determinations, production history analysis,

financial statement and ratio analysis, commitment

advances, discount rates, price deck formulation, financial

covenants, steps to cure an over-advance situation, and

ALLL considerations. Specific guidelines typically cover

the following areas:

• Lending objectives, risk appetite, portfolio limits,

target market, and concentration limits;

• Methodology and requirements for monitoring O&G

markets, including pricing, supply and demand trends,

overall market trends, and industry analysis;

• Board and committee oversight over the O&G lending

and engineering departments;

• Officer and committee lending limits;

• Borrowing base calculations and risk-adjustments;

• Price deck considerations and adjustments;

• Advance rates, risk-adj

usted values for PDP, PDNP,

and PUD reserves, and requirement to risk adjust the

discount value of nonproducing reserves before

applying advance rates;

• Frequency and required details of borrowing base

red

eterminations and price deck revaluations;

• Requirements for independent engineering reports and

analysis thereof;

• Well concentration guidelines and maximum per

single well limits;

• Financial covenants, minimum ratio and other

financial information requirements, and review

requirements (e.g. current ratio, fixed charge

coverage, cash flow coverage, leverage ratios);

• Collateral valuation requirements, including required

remaining collateral at payout;

• Renewal and restructuring guidelines, including

nonaccrual and troubled debt restructuring

implications;

• Remedies for declining collateral or over-advanced

situations, such as Monthly Commitment Reductions,

pledge of additional reserves as collateral, and sale of

non-productive reserves;

• Minimum required insurance (including property,

liability, and environmental);

• Defined loan safety or coverage factors and/or loan

value policies, including other debt that is “pari-

passu” (i.e. all debts sharing equally in the production

cash flows available to amortize debt);

• Typical amortization, payout, and loan repayment

terms, including maximum terms for production

revolvers and term loans;

• Guarantor requirements;

• Hedging requirements, policies, and limitations;

• Stress-testing and sensitivity analysis and

requirements thereof; and

• Monitoring requirements for the risks inherent in

loans dependent on royalty interests in production

revenues for repayment.

Credit Risk Rating Assessment and Classification

Guidelines

An appropriate O&G loan policy also addresses specific

credit risk review procedures for the O&G portfolio and

O&G loan grading criteria. Risk rating definitions should

be clearly defined. RBL that are adequately protected by

the current sound worth and debt service capacity of the

borrower, guarantor, or underlying collateral generally will

not be adversely classified for supervisory purposes.

However, if any of the following circumstances are present,

a more in-depth and comprehensive analysis of the credit is

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needed to determine whether the loan has potential or well-

defined weaknesses:

• The loan balance exceeds 65 percent of the PV of

FNR of PDP, or the cash flow analysis indicates that

the loan will not amortize within the reserve half-life;

• The credit is not performing in accordance with

contractual terms (repayment of interest and

principal);

• Advance rates exceed the institution’s limits or

industry standards for proved reserves;

• Frequent over-advances occur at subsequent

borrowing base redeterminations;

• Excessive operating leverage;

• Covenant defaults;

• Delinquent payables, or other evidence of poor

working capital management;

• Significant current or likely future disruptions in

production;

• Frequent financial statement revisions or changes in

chosen accounting method;

• Maintenance or capital expenditures significantly

exceed budgeted forecasts; or

• The credit is identified by the institution as a

“distressed” credit.

Examiners are to consider all information relevant to

evaluating the prospects that the loan will be repaid,

including the borrower’s creditworthiness, the cash flow

provided by the borrower’s operation, the collateral

supporting the loan, integrity and reliability of the

engineering data, borrowing base considerations, primary

source of repayment, and any support provided by

financially responsible guarantors and co-borrowers. If the

borrower’s circumstances reveal well-defined weaknesses,

adverse classification of the loan relationship is likely

warranted. The level and severity of classification of

distressed, collateral-dependent RBLs will depend on the

quality of the underlying collateral, based on the most recent

re-determined and risk-adjusted borrowing base that is

contractually obligated to be funded.

The portion of the loan commitment(s) secured by the NPV

of total risk-adjusted proved reserves should be classified

Substandard. When the potential for loss may be mitigated

by the outcome of certain pending events, or when loss is

expected but the amount of the loss cannot be reasonably

determined, the remaining balance secured by the NPV of

total unrisked proved reserves should be classified

Doubtful. The portion of the loan commitment(s) that

exceeds 100 percent of the NPV of total unrisked proved

reserves, and is uncollectible, should be classified Loss.

These guidelines may be adjusted depending on the

borrower’s specific situation and should not replace

examiner judgment.

The following tables illustrate an example of the rating

methodology for a classified borrower. Actual pricing,

discount rates, and risk adjustment factors applied by the

institution may vary according to current market conditions

and the nature of the reserves. Examiners should closely

review the key assumptions made by the institution in

arriving at the current collateral valuation.

Example: Collateral Valuation ($ Million)

Discounted NPV at 9% and using NYMEX Strip Pricing

Valuation Hedges PDP PDNP PUD Total

Basis Proved

Unrisked $10 $50 $20 $40 $120

NPV

Risk 100% 100% 75% 50%

adjustment

factors

Risked & $10 $50 $15 $20 $95

Adjusted

NPV

Total collateral value: $95

Example: Classification ($ Million)

Borrowing base commitment on RBL is $125 million

TC Pass SM II III IV

RBL $125 $95 $25 $5

Total $125 $95 $25 $5

TC: Total Commitment SM: Special Mention

II: Substandard III: Doubtful IV: Loss

Note: The $25 million of Doubtful represents the difference

between the unrisked NPV and the risked NPV. If the

borrower's prospects for further developing PDNP and PUD

reserves to producing status are unlikely or not supported by

a pending event, this amount should be reflected as Loss.

Institutions should follow accounting principles when

determining whether a loan should be placed on nonaccrual.

Each extension should be independently evaluated to

determine whether it should be on nonaccrual; that is,

nonaccrual status should not be automatically applied to

multiple loans or extensions of credit to a single borrower if

only one loan meets the criteria for nonaccrual status.

However, multiple loans to one borrower that are structured

as pari-passu to principal and interest and supported by the

same repayment source should not be treated differently for

nonaccrual or troubled debt restructuring purposes,

regardless of collateral lien position.

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Real Estate Loans

General

Real estate loans 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 an

institution'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 decline in 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 repayment 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 to ascertain the soundness of its

mortgage loan operations as well as the liquidity contained

in the account. Institutions generally 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.

Real Estate Lending Standards

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. These policies generally enable management to

effectively identify, measure, monitor, and control the risks

associated with real estate lending. The level and

complexity of risk-monitoring techniques for real estate

lending typically is commensurate with the level of real

estate activity and the nature and complexity of the

institution’s market. Within these general parameters, the

regulation specifically requires an institution to establish

policies that include:

• Portfolio diversification standards;

• Prudent underwriting standards including loan-to-

value limits;

• Loan administration procedures;

• Documentation, approval and reporting requirements;

and

• Procedures for monitoring real estate markets within

the institution's lending area.

These policies also should consider the Interagency

Guidelines for Real Estate Lending Policies and must be

reviewed and approved at least 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.

The Interagency Guidelines for Real Estate Lending

Policies indicate that institutions should establish their own

internal LTV limits consistent with their needs. These

internal limits should not exceed the following

recommended supervisory limits:

• 65 percent for raw land;

• 75 percent for land development;

• 80 percent for commercial, multi-family, and other

non-residential construction;

• 85 percent for construction of a 1-to-4 family

residence;

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• 85 percent for improved property; and

• Owner-occupied 1-to-4 family home loans have no

suggested supervisory LTV limits. 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.

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.

Management and the board at each institution typically

establish an appropriate internal process for the review and

approval of loans that do not conform to internal policy

standards. The approval of any loan that is an exception to

policy typically is supported by a written justification that

clearly details all of the relevant credit factors supporting

the underwriting decision. Exception loans of a significant

size often are individually reported to the board.

Prudent management and boards monitor compliance with

internal policies and maintain reports of all exceptions to

policy. Examiners should review loan policy exception

reports to determine whether exceptions are adequately

documented and appropriate in light of all the relevant credit

considerations.

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:

• The size and financial condition of the institution;

• The nature and scope of the institution's real estate

lending activities;

• The quality of management and internal controls;

• The size and expertise of the lending and

administrative staff; and

• Market conditions.

The institution should not be considered in nonconformance

of the standards as a result of minor exceptions or

inconsistencies. Rather, examiners are to assess

management’s overall practices and performance when

assessing conformance with the standards.

Examination procedures for various real estate loan

categories are included in the ED Modules.

Commercial Real Estate Loans

These loans comprise a major portion of many banks' loan

portfolios. When problems exist in the real estate markets

that the institution 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:

• An excess of similar projects under construction.

• Rent concessions or sales discounts resulting in cash

flow below the level projected in the original

appraisal.

• Concessions on finishing tenant space, moving

expenses, and lease buyouts.

• Delinquent lease payments from major tenants.

• Changes in concept or plan: for example, a

condominium project converting to an apartment

project.

• Land values that assume future rezoning.

• Construction delays resulting in cost overruns, which

may require renegotiation of loan terms.

• Slow leasing or lack of sustained sales activity and/or

increasing cancellations, which may result in

protracted repayment or default.

• Lack of any sound feasibility study or analysis.

• Periodic construction draws that exceed the amount

needed to cover construction costs and related

overhead expenses.

• Tax arrearages.

• Identified problem credits, past due and non-accrual

loans.

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Real Estate Construction Loans

A well-underwritten 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 which specify type and extent of

institution involvement. Such policies generally define

procedures for controlling disbursements and collateral

margins and assuring timely completion of the projects and

repayment of the institution's loans.

Before entering a construction loan agreement, it is

appropriate for the institution to investigate the character,

expertise, and financial standing of all related parties.

Documentation files would then include background

information concerning reputation, work and credit

experience, and financial statements. Such documentation

indicates 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

institution should realize that appraised collateral values are

not usually met until funds are advanced and improvements

made.

The institution, the builder, and the property owner typically

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 pre-established 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 percent of the value with 10

percent 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.” A key

feature of these transactions is that the institution 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 percent 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. Acquisition, Development,

and Construction (ADC) arrangements that are in substance

real estate investments of the institution should be reported

accordingly.

The following are the basic types of construction lending:

• Unsecured Front Money - Uns

ecured front money

loans are working capital advances to a borrower who

may be engaged in a new and unproven venture.

Many bankers believe that unsecured front money

lending is not prudent unless the institution is involved

in the latter stages of construction financing. A

builder planning to start a project before construction

funding is obtained often uses front money loans. The

funds may be used to acquire or develop a building

site, eliminate title impediments, pay architect or

standby fees, and/or meet minimum working capital

requirements established by construction lenders.

Repayment often comes from the first draw against

construction financing. Unsecured front money loans

used for a developer's equity investment in a project or

to cover initial costs overruns are symptomatic of an

undercapitalized, inexperienced or inept builder.

• Land Development Loans - L

and development loans

are generally secured purchase or development loans

or unsecured advances to investors and speculators.

Secured purchase or development loans are usually a

form of financing involving the purchase of land and

lot development in anticipation of further construction

or sale of the property. A land development loan

should be predicated upon a proper title search and/or

mortgage insurance. The loan amount should be

based on appraisals on an "as is" and "as completed"

basis. Projections should be accompanied by a study

explaining the effect of property improvements on the

market value of the land. There should be a sufficient

spread between the amount of the development loan

and the estimated market value to allow for

unforeseen expenses. Appropriate repayment

programs typically are structured to follow the sales or

development program. In the case of an unsecured

land development loan to investors or speculators, it is

prudent for institution management to analyze the

borrower's financial statements for sources of

repayment other than the expected return on the

property development.

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• Commercial Construction Loans - Loans financing

commercial construction projects are usually

collateralized, and such collateral is generally

identical to that for commercial real estate loans.

Supporting documentation should include a recorded

mortgage or deed of trust, title insurance policy and/or

title opinions, appropriate liability insurance and other

coverages, land appraisals, and evidence that taxes

have been paid to date. Additional documents relating

to commercial construction loans include loan

agreements, takeout commitments, tri-party (buy/sell)

agreements, completion or corporate bonds, and

inspection or progress reports.

• Residential Construction Loans - Residential

construction loans may be made on a speculative basis

or as prearranged permanent financing. Smaller banks

often engage in this type of financing and the

aggregate total of individual construction loans may

equal a significant portion of their capital funds.

Prudence dictates that permanent financing be assured

in advance because the cost of such financing can

have a substantial effect 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 realistic marketability in favorable

and unfavorable market conditions is also an

important consideration.

In addit

ion to normal safeguards such as a recorded

first mortgage, acceptable appraisal, construction

agreement, draws based on progress payment plans

and inspection reports, an institution 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 is typically 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

institution 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)

typically are made on the entire project. A

comprehensive inventory list shows each lot number,

type of structure, release price, sales price, and loan

balance.

The exposure in any type of construction lending is that the

full value of the collateral does not exist at the time the loan

is granted. Therefore, it is important for management to

ensure funds are used properly to complete construction or

development of the property serving as collateral. If default

occurs, the institution 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 states 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,

institution management should ensure that it has enacted

policies and retained sufficiently trained personnel before

engaging in this type of lending.

Home Equity Loans

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

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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.

Institutions that make these kinds of loans typically adopt

specific policies and procedures for dealing with this

product line. Management expertise in mortgage lending

and open-end credit procedures is critical to the appropriate

administration of the portfolio. Another major concern is

that borrowers will become overextended and the institution

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 institution 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 institution'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.

While home equity lending is considered to be fairly low-

risk, subprime home equity loans and lending programs

exist at some banks. These programs have a higher level of

risk than traditional home equity lending programs.

Individual or pooled home equity loans that have subprime

characteristics should be analyzed using the information

provided in the subprime section of this Manual.

Agricultural Loans

Introduction

Agricultural loans are an important component of many

community institution 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 institution is taking reasonable steps to deal with

these external risk factors. Accordingly, loan restructurings

or extended repayment terms, 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 institution’s

response to these challenges will be considered in

supervisory decisions.

Agricultural Loan Types and Maturities

Production or 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.

Feeder Livestock Loans - Sho

rt-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.

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Breeder Stock Loans - 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.

Machinery and Equipment Loans

- 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 - L

ong-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.

Carryover Loans

- 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 institution.

gricultural 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.

Financial and Other Credit Information

- As with any type

of lending, sufficient information must be available so that

the institution 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.

nstitutions 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 credit size, 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 institution’s agricultural credit lines, and all of

its larger or more significant ones, should be sufficiently

supported by the financial information mentioned.

Cash Flow Analysis

- History 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 evident in the

institution’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.

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

based on 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

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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 institution may

perfect a lien on real estate as an abundance of caution.

Examiner review of agricultural related collateral valuations

varies depending on the type of security involved. Real

estate collateral should be reviewed using normal

procedures. 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; so, 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). The extent of use and

level of maintenance received significantly affect

machinery and equipment values. 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

reasonableness check on the 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 institution 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 borrower relationship strained.

Structuring - O

rderly 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 institution 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.

dministration of Agricultural Loans

Two aspects of prudent loan administration deserve

emphasis: collateral control and renewal practices for

production loans.

Collateral Control - P

roduction 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 institution does not monitor and exercise

sufficient control over the disposition of the proceeds from

the sale. 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 credit soundness, 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 production loan extensions or renewals.

In these situations, the institution 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:

• T

he 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.

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• 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.

• The institution 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

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 institution 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.

That portion of an agricultural loan(s) or line of credit,

which is secured by grain, feeder livestock, and/or breeder

livestock, will generally be withheld from adverse

classification. The basis for this approach is that grain and

livestock are highly marketable and provide good protection

from credit loss. However, that high marketability also

poses potential risks that must be recognized and controlled.

The following conditions must therefore be met in order for

this provision to apply:

• The institution must take reasonable steps to verify the

existence and value of the grain and livestock. This

generally means that on-site inspections must be made

and documented. Although the circumstances of each

case must be taken into account, the general policy is

that, for the classification exclusion to apply,

inspections should have been performed not more than

90 days prior to the examination start date for feeder

livestock and grain collateral, and not more than six

months prior to the examination start date for breeder

stock collateral. Copies of invoices or bills of sale are

acceptable substitutes for inspection reports prepared

by institution management, in the case of loans for the

purchase of livestock.

• Loans secured by grain warehouse receipts are

generally excluded from adverse classification, up to

the market value of the grain represented by the

receipts.

• The amount of credit to be given for the livestock or

grain collateral should be based on the daily,

published, market value as of the examination start

date, less marketing and transportation costs, feed and

veterinary expenses (to the extent determinable), and,

if material in amount, the accrued interest associated

with the loan(s). Current market values for breeder

stock may be derived from local or regional

newspapers, area auction barns, or other sources

considered reliable. If such valuations for breeding

livestock cannot be obtained, the animals’ slaughter

values may be used.

• The institution must have satisfactory practices for

controlling sales proceeds when the borrower sells

livestock and feed and grain.

• The institution must have a properly perfected and

enforceable security interest in the assets in question.

Examiners should exercise great caution in granting the

grain and livestock exclusion from adverse classification in

those instances where the borrower is highly leveraged, or

where the debtor’s basic operational viability is seriously in

question, or if the institution 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, institution 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.

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.

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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 are generally verified and documented during the

institution’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 institution, 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 should be considered.

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

institution 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 institution 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 institution’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 institution 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.

here 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 operation’s size; 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 classification severity 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.

Installment Loans

An installment loan portfolio is usually comprised of a large

number of small loans scheduled to be amortized over a

specific period. Most installment 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 installment 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.

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Direct installment lending policies typically 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 typically addresses direct

payment to the institution versus 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.

Lease Accounting

ASC Topic 840, Leases, is the current lease accounting

standard for non-public business entities and entities that

have not adopted ASC Topic 842, Leases. ASC Topic 842

is effective for public business entities (as defined in U.S.

GAAP) and will become effective for banks that are not

public business entities, for fiscal years beginning after

December 15, 2021, and interim reporting periods within

fiscal years beginning after December 15, 2022. As such, a

calendar year end non-public business entity’s first reporting

period will be December 31, 2022. Early adoption is

permitted.

Direct Lease Financing

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 property type and its marketability in the

event of default or lease termination. Those latter

considerations do not radically alter the manner in which an

examiner evaluates collateral for a lease. The assumption is

that the lessee/borrower will generate sufficient funds to

liquidate the lease/debt. Sale of leased property/collateral

remains a secondary repayment source 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 institution 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 institution and its customer, an order is usually written

requesting the institution to purchase the property. Upon

receipt of that order, the institution 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 institution 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.

Lessor Accounting under ASC Topic 840

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 ASC Topic 840, Leases. Familiarity

with ASC Topic 840 is a prerequisite for the management

of any institution engaging in or planning to engage in direct

lease financing. The following terms are commonly

encountered in direct lease financing:

• Net Lease, one in which the institution is not directly

or indirectly obligated to assume the expenses of

maintaining the equipment. This restriction does not

prohibit the institution from paying delivery and set up

charges on the property.

• Full Payout Lease, one for which the institution

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.

• Leveraged Lease, in which the institution as lessor

purchases and becomes the equipment owner 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 an institution should not enter

into a leveraged lease transaction with any party to

whom it would not normally extend unsecured credit.

• Rentals, which include only those payments

reasonably anticipated by the institution at the time the

lease is executed.

Lessor Accounting under ASC Topic 842

ASC Topic 842, Leases does not fundamentally change

lessor accounting; however, it aligns terminology between

lessee and lessor accounting and brings key aspects of lessor

accounting into alignment with the FASB’s new revenue

recognition guidance in ASC Topic 606. As a result, the

classification difference between direct financing leases and

sales-type leases for lessors moves from a risk-and-rewards

principle to a transfer of control principle. As such, an

institution as lessor is required to classify a lease as a sales-

type, direct financing, or operating leases. Additionally,

there is no longer a distinction in the treatment of real estate

and non-real estate leases by lessors.

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Leases classified as leveraged leases prior to the adoption of

ASC Topic 842 may continue to be accounted for under

ASC Topic 840 unless subsequently modified. ASC Topic

842 eliminates leveraged lease accounting for leases that

commence after an institution adopts the new accounting

standard.

For more information refer to the Call Report Glossary for

the accounting for leases or ASC Topic 842.

Examiner Consideration

Examiners should determine whether bank management

carefully evaluates all lease variables, including the

estimate of the residual value. Institutions may be able to

realize unwarranted lease income in the early years of a

contract by manipulating the lease variables. In addition, an

institution 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

institution 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 lease financing

activities are included in the ED Modules in the Loan

References section.

Floor Plan Loans

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 institution

establishes a line of credit for the borrower and authorizes

the good’s manufacturer to draw drafts on the institution in

payment for goods shipped. The institution 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 institution 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 institution 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 institution and the dealer. Trust

receipts may result from drafting agreements between an

institution and a manufacturer for the benefit of a dealer. In

other instances, the dealer may order inventory, bring titles

or invoices to the institution, 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 an institution enacts realistic

handling policies and ensures that its collateral position is

properly protected.

Examination procedures and examiner considerations for

reviewing floor plan lending activities are included in the

ED Modules in the Loan References section.

Check Credit and Credit Card Loans

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 pre-established 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 institution, and the customer is notified that

the funds have been transferred. In a cash reserve system,

customers must request that the institution transfer funds

from their pre-established 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 pre-established line

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of credit. In that method, demand deposit accounts are not

affected. In all three systems, the institution 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 institution credit card plans are similar. The

institution 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 institution. Merchants

also may be assessed a fee for imprinters or promotional

materials. The merchant deposits the institution credit card

sales draft at the institution and receives immediate credit

for the discounted amount. The institution assumes the

credit risk and charges the nonrecourse sales draft to the

individual customer's credit card account. Monthly

statements are rendered by the institution 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 institution or dispensing machines. Those

advances accrue interest from the transaction date. An

institution may be involved in a credit card plan in three

ways:

• 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.

• 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.

• Licensee Bank, which is the same as sublicensee

institution, 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.

Check credit and credit card loan policies typically address

procedures for careful screening of account applicants;

establishment of internal controls to prevent interception of

cards before delivery, merchants from obtaining control of

cards, or customers from making fraudulent use of lost or

stolen card; 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 catch-up of delinquent

principal; and provisions that preclude automatic reissuance

of expired cards to obligors with charged-off balances or an

otherwise unsatisfactory credit history with the institution.

Examination procedures for reviewing these activities are

included in the ED Modules. Also, the FDIC has separate

manuals on Credit Card Specialty Bank Examination

Guidelines and Credit Card Securitization Activities.

Credit Card-related Merchant Activities

Merchant credit card activities basically involve the

acceptance of credit card sales drafts for clearing by a

financial institution (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

contingent liabilities.

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 include

clear and detailed acceptance standards for merchants, such

as the following:

• Scrutinizing prospective merchants using the same

care and diligence used in evaluating prospective

borrowers.

• Closely monitoring merchants with controls to ensure

that early warning signs are recognized so that

problem merchants can be removed from a clearing

institution's program promptly to minimize loss

exposure.

• Establishing an account administration program that

incorporates periodic reviews of merchants' financial

statements and business activities in cases of

merchants clearing large dollar volumes.

• Establishing an internal periodic reporting system of

merchant account activities regardless of the amount

or number of transactions cleared, with these reports

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reviewed for irregularities so problematic merchant

activity is identified quickly.

• Developing policies that follow the guidelines

established by the card issuing networks.

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

typically develops 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 would supervise any third party engaged to

perform services for any aspect of the institution's

operations. Also, institutions typically and appropriately

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 ED Modules in the

Supplemental Modules Section and in the Credit Card

Activities Manual.

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OTHER CREDIT ISSUES

Appraisals

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 banking agencies.

When evaluating collateral, the three valuation approaches

are not equally appropriate.

• Cost Approach - In this approach, the appraiser

estimates the reproduction cost of the building and

improvements, deducts estimated depreciation, and

adds the value of the land. The cost approach is

particularly helpful when reviewing draws on

construction loans. However, as the property

increases in age, both reproduction cost and

depreciation become more difficult to estimate.

Except for special purpose facilities, the cost approach

is usually inappropriate in a troubled real estate

market because construction costs for a new facility

normally exceed the market value of existing

comparable properties.

• Market Data or Direct Sales Comparison

Approach - This approach examines the price of

similar properties that have sold recently in the local

market, estimating the value of the subject property

based on the comparable properties' selling prices. It

is very important that the characteristics of the

observed transactions be similar in terms of market

location, financing terms, property condition and use,

timing, and transaction costs. The market approach

generally is used in valuing owner-occupied

residential property because comparable sales data is

typically available. When adequate sales data is

available, an analyst generally will give the most

weight to this type of estimate. Often, however, the

available sales data for commercial properties is not

sufficient to justify a conclusion.

• The Income Approach - The economic value of an

income-producing property is the discounted value of

the future net operating income stream, including any

"reversion" value of property when sold. If

competitive markets are working perfectly, the

observed sales price should be equal to this value. For

unique properties or in depressed markets, value based

on a comparable sales approach may be either

unavailable or distorted. In such cases, the income

approach is usually the appropriate method for valuing

the property. 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

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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.

Valuation of Troubled Income-Producing Properties

When an income property is experiencing financial

difficulties due to general market conditions or due to its

own characteristics, data on comparable property sales is

often 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. 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. If

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.

Appraisal Regulation

Title XI of the 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 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 Appraisal 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 the Appraisal

Subcommittee. A responsibility of the Appraisal

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 Appraisal

Subcommittee also has the authority to temporarily waive

the credential requirement if certain criteria are met. The

Appraisal Subcommittee gets its funding by charging state

certified and licensed appraisers an annual registration fee.

The fee income is used to cover Appraisal 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, institution 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 is a residential real estate

transaction that has a transaction value of $400,000

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;

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(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;

(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;

(13) The transaction is a commercial real estate transaction

that has a transaction value of $500,000 or less; or

(14) The transaction is exempted from the appraisal

requirement pursuant to the rural residential

exemption under 12 U.S.C. 3356.

The regulation also requires an institution to obtain an

appropriate evaluation of the real property collateral that

is consistent with safe and sound banking practices for a

transaction that does not require the services of a state

certified or licensed appraiser per exemption (1), (5), (7),

(13), or (14).

ection 323.4 establishes minimum standards for all

appraisals in connection with federally related transactions.

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. The regulation also requires

that the appraisal report contain the appraiser's certification

that the appraisal was prepared in conformance with

USPAP.

In addition, the regulation requires appraisals for federally

related transactions to be subject to appropriate review for

compliance with USPAP. Specific review procedures in an

institution's written appraisal program that produce some

form of documented evidence would facilitate meeting this

regulatory requirement. Procedures for maintaining some

form of documented evidence of the review of other

appraisals help ensure those appraisals facilitate making

informed lending decisions. Examiners should note that

such evidence could take the form of an appraisal checklist

that includes the signature of an appropriately trained

external person or an internal staff member, indicates the

appraisal was reviewed, and finds that all USPAP standards

were met. An effective appraisal program’s review

escalation procedures will facilitate internal staff’s ability to

take appropriate action to address appraisals that do not

comply with USPAP.

Adherence to the appraisal regulations should be part of the

examiner's overall review of the lending function. 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

Documentation Modules.

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.

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Appropriate evidence could include an issuer's certification

of compliance.

All apparent 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.

Interagency Appraisal and Evaluation Guidelines

The Interagency Appraisal and Evaluation Guidelines dated

December 2, 2010 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 that are consistent with

the appraisal regulation.

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 typically are

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.

When analyzing individual transactions, examiners should

review an appraisal or evaluation to determine whether the

methods, assumptions, and findings are reasonable and

comply with the agencies' appraisal regulations and the

institution’s internal 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 will be cited in examination reports

and may be criticized for unsafe and unsound banking

practices. Deficiencies will require corrective action.

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. Effective programs:

• Establish selection criteria and procedures to evaluate

and monitor the ongoing performance of individuals

who perform appraisals or evaluations;

• Provide for the independence of the person

performing appraisals or evaluations;

• Identify the appropriate appraisal for various lending

transactions;

• Establish criteria for contents of an evaluation;

• Provide for the receipt of the appraisal or evaluation

report in a timely manner to facilitate the underwriting

decision;

• Assess the validity of existing appraisals or

evaluations to support subsequent transactions;

• Establish criteria for obtaining appraisals or

evaluations for transactions that are otherwise exempt

from the agencies' appraisal regulations; and

• Establish internal controls that promote compliance

with these program standards.

Selection of Individuals Who May Perform Appraisals and

Evaluations - An institution's program establishes criteria to

select, evaluate, and monitor the performance of the

individual(s) who performs a real estate appraisal or

evaluation. Appropriate criteria ensure that:

• T

he selection process is non-preferential and

unbiased;

• The individual selected possesses the requisite

education, expertise and competence to complete the

assignment;

• The individual selected is capable of rendering an

unbiased opinion; and

• The individual selected is independent and has no

direct or indirect interest, financial or otherwise, in the

property or the transaction.

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. Also, an institution may not use an appraisal that

has been “readdressed” – appraisal reports that are altered

by the appraiser to replace any references to the original

client with the institution’s name. 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.

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. In

addition, individuals independent from the loan production

area should oversee the selection of appraisers and

individuals providing evaluation services. 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. That is, no

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single person should have sole authority to render credit

decisions on loans which they ordered or reviewed

appraisals or evaluations.

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 abstain from any vote or

approval involving loans on which they performed an

appraisal or evaluation.

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 $400,000

($500,000 for commercial real estate transactions) 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 S

tandards - The agencies' appraisal

regulations include five minimum standards for the

preparation of an appraisal. The appraisal must:

• C

onform to generally accepted appraisal standards as

evidenced by the Uniform Standards of Professional

Appraisal Practice (USPAP) promulgated by the

Appraisal Standards Board (ASB) of the Appraisal

Foundation unless principles of safe and sound

banking require compliance with stricter standards.

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;

• Be written and contain sufficient information and

analysis to support the institution's decision to engage

in the transaction. 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.

• Analyze and report appropriate deductions and

discounts for proposed construction or renovation,

partially leased buildings, non-market lease terms, and

tract developments with unsold units. 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;

• Be based upon the definition of market value set forth

in the regulation. Each appraisal must contain an

estimate of market value, as defined by the agencies'

appraisal regulations; and

• Be performed by state licensed or certified appraisers

in accordance with requirements set forth in the

regulation.

Appraisal O

ptions - An appraiser typically uses three

market value approaches to analyze the value of a property

cost, income, and sales market. The appraiser reconciles the

results of each approach 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.

n 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;

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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.

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.

Additionally, p

rudent institutions establish criteria for

obtaining appraisals or evaluations for safety and soundness

reasons for transactions that are otherwise exempt from the

agencies' appraisal regulations.

Evaluation Content

- Prudent standards for preparing

evaluations typically require that evaluations:

• B

e written;

• Include the preparer's name, address, and signature,

and the effective date of the evaluation;

• Describe the real estate collateral, its condition, its

current and projected use;

• Describe the source(s) of information used in the

analysis;

• Describe the analysis and supporting information; and

• Provide an estimate of the real estate's market value,

with any limiting conditions.

An appropriate evaluation report includes 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 appropriate evaluation provides an estimate of value to

assist the institution in assessing the soundness of the

transaction. Prudent practices may include more detailed

evaluations as an institution engages in more complex real

estate-related financial transactions, or as its overall

exposure increases. 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 describes the current and

expected use of the property and includes an analysis of the

property's rental income and expenses.

Qualifications of Evaluation Providers

- 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. Well-managed institutions

document the qualifications and experience level of

individuals whom the institution deems acceptable to

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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 institution may 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 includes 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.

he decision to reappraise or reevaluate the real estate

collateral should be guided by the regulatory 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 would 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.

Program Compliance

- Appropriate appraisal and

evaluation programs establish effective internal controls

that promote compliance with the program's standards. An

individual familiar with the appraisal regulations should

ensure that the institution's appraisals and evaluations

comply with the appraisal regulations and the institution's

program. Typically, loan administration files 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. Examiners should determine whether

corrective action for noted deficiencies was undertaken by

the individual who prepared the appraisal or evaluation.

ffective appraisal and evaluation programs 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 are typically designed

to verify that the methods, assumptions, and conclusions are

reasonable and appropriate for the transaction and the

property. These procedures 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 are

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. Examiners should be

mindful that changes to an appraisal's estimate of value are

permitted only as a result of a review conducted by an

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appropriately qualified state licensed or certified appraiser

in accordance with Standard III of USPAP.

Portfolio Monitoring

- The institution also typically

develops 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.

xamination Treatment

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. A new appraisal might also be needed

to determine the proper classification for examination

purposes of a collateral dependent loan.

Loan Participations

A loan participation is a sharing or selling of ownership

interests in a loan between two or more financial

institutions. Normally, a lead institution originates the loan

and sells ownership interests to one or more participating

banks at the time the loan is closed. The lead (originating)

institution 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.

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.

Accounting

The proper accounting treatment for loan participations is

governed by ASC Topic 860, Transfers and Servicing, that

applies to the transferor (seller) of assets and the transferee

(purchaser).

Before considering whether the conditions for a sale have

been met, the transfer of a portion of an entire financial asset

must first meet the definition of a participating interest.

A participating interest in an entire financial asset, as

defined in ASC Topic 860, has all of the following

characteristics:

• From the date of transfer, it must represent a

proportionate (pro-rata) ownership interest in the

entire financial asset;

• From the date of the transfer, all cash flows received

from the entire financial asset, except any cash flows

allocated as compensation for servicing or other

services performed (which must not be subordinated

and must not significantly exceed an amount that

would fairly compensate a substitute service provider

should one be required), must be divided

proportionately among the participating interest

holders in an amount equal to their share of

ownership;

• The rights of each participating interest holder

(including the lead lender) must have the same

priority, no interest is subordinated to another interest,

and no participating interest holder has recourse to the

lead lender or another participating interest holder

other than standard representations and warranties and

ongoing contractual servicing and administration

obligations; and

• No party has the right to pledge or exchange the entire

financial asset unless all participating interest holders

agree to do so.

If the financial asset meets the definition of a participating

interest, the institution must then determine if the

participating interest qualifies for sale treatment. The sale

criteria focus on whether or not control is effectively

transferred to the purchaser.

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A transfer of an entire financial asset, a group of financial

assets, or a participating interest in an entire financial asset

in which the transferor surrenders control over those

financial assets shall be accounted for as a sale if and only

if all of the following conditions are met:

• The transferred financial assets have been isolated

from the seller, meaning that the purchaser's interest in

the loan is presumptively beyond the reach of the

seller and its creditors, even in bankruptcy or other

receivership;

• Each purchaser has the right to pledge or exchange its

interest in the loan, and there are no conditions that

both constrain the purchaser from taking advantage of

that right to pledge or exchange and provide more

than a trivial benefit to the seller; and

• The seller or their agents do not maintain effective

control over the transferred financial assets. Examples

of a seller maintaining effective control include an

agreement that both entitles and obligates the seller to

repurchase or redeem the purchaser's interest in the

loan prior to the loan's maturity, an agreement that

provides the seller with the unilateral ability to cause

the purchaser to return its interest in the loan to the

seller (other than through a cleanup call), or an

agreement that permits the purchaser to require the

seller to repurchase its interest in the loan at a price so

favorable to the purchaser that it is probable that the

purchaser will require the seller to repurchase.

Right to Repurchase

Some loan participation agreements may give the seller a

contractual right to repurchase the participated interest in

the loan at any time. In this case, the seller's right to

repurchase the participation effectively provides the seller

with a call option on a specific asset that would preclude

sale accounting if the asset is not readily obtainable in the

marketplace. If a loan participation agreement contains

such a provision, freestanding or attached, it constrains the

purchaser from pledging or exchanging its participating

interest, and results in the seller maintaining effective

control over the participating interest. In such cases, the

transfer would be accounted for as a secured borrowing.

For additional information on the transfer of loan

participations refer to the Call Report Glossary entry:

“Transfers of Financial Assets”.

Recourse Arrangements

Recourse arrangements may, or may not, preclude loan

participations from being accounted for as sales for

financial reporting purposes. The date of the participation

and the formality of the recourse provision affect the

accounting for the transaction. Formal recourse provisions

may affect the accounting treatment of a participation

depending upon the date that the participation is transferred

to another institution. Implicit recourse provisions would

not affect the financial reporting treatment of a participation

because the accounting standards look to the contractual

terms of asset transfers in determining whether or not the

criteria necessary for sales accounting treatment have been

met. Although implicit recourse provisions would not affect

the accounting treatment of a loan participation, they may

affect the risk-based capital treatment of a participation.

If an originating selling institution has transferred a loan

participation to a participating institution with recourse on

or before December 31, 2001, the existence of the recourse

obligation in and of itself does not preclude sale accounting

for the transfer. If a loan participation transferred with

recourse on or before December 31, 2001, meets the three

conditions then in effect for the transferor to have

surrendered control over the transferred assets, the transfer

should be accounted for as a sale for financial reporting

purposes. However, a loan participation sold with recourse

is subject to the banking agencies’ risk-based capital

requirements.

If an originating selling institution transfers a loan

participation with recourse on or after January 1, 2002, the

participation generally will not be considered isolated from

the originating lender in an FDIC receivership. Section

360.6 of the FDIC Rules and Regulations limits the FDIC's

ability to reclaim loan participations transferred without

recourse as defined in the regulations, but does not limit the

FDIC's ability to reclaim loan participations transferred

with recourse. Under Section 360.6, a participation subject

to an agreement that requires the originating lender to

repurchase the participation or to otherwise compensate the

participating institution due to a default on the underlying

loan is considered a participation with recourse. As a result,

a loan participation transferred with recourse on or after

January 1, 2002, generally should be accounted for as a

secured borrowing and not as a sale for financial reporting

purposes. This means that the originating lender should not

remove the participation from its loan assets on the balance

sheet, but should report the loan participation as a secured

borrowing.

Call Report Treatment

When a loan participation meets the definition of a

participating interest and the conditions for sale treatment

are met, the seller removes the participated interest in the

loan from the balance sheet. The purchaser reports the

participating interest in “Loans” in the Report of Condition,

and in Call Report Schedule RC-C - Loans and Lease

Financing Receivables, based upon collateral, borrower, or

purpose. When a loan participation does not meet the

definition of a participating interest, or if a transfer of a

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participating interest does not meet all of the conditions for

sale accounting, the transfer must be reported as a secured

borrowing with a pledge of collateral. In these situations,

because the transferred loan participation does not qualify

for sale accounting, the transferring institution must

continue to report the transferred participation (as well as

the retained portion of the loan) in “Loans” in the Report of

Condition, based upon collateral, borrower, and purpose.

As a consequence, the transferred loan participation should

be included in the originating lender’s loans and leases for

purposes of determining the appropriate level for the

institution’s allowance for loan and lease losses. The

transferring institution should also report the transferred

loan participation as a secured borrowing in “Other

Borrowed Money” in the Report of Condition.

Independent Credit Analysis

An institution purchasing a participation loan is expected to

perform the same degree of independent credit analysis on

the loan as if it were the originator. To determine if a

participation loan meets its credit standards, a participating

institution 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 may be

evidence that the participating institution has not been

prudent in its credit decision.

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

institution must ascertain that the selling institution will

provide complete and timely credit information on a

continuing basis.

The procedures for purchasing loan participations should be

provided for in the institution'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.

Participation Agreements

A participation loan can present unique problems if the

borrower defaults, the lead institution 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, comprehensive participation agreements

specifically include the following considerations:

• The obligation of the lead institution to furnish timely

credit information and to provide notification of

material changes in the borrower's status;

• Requirements that the lead institution consult with

participants prior to modifying any loan, guaranty, or

security agreements and before taking any action on

defaulted loans;

• The specific rights and remedies available to the lead

and participating banks upon default of the borrower;

• Resolution procedures when the lead and participating

banks cannot agree on the handling of a defaulted

loan;

• Resolution of any potential conflicts between the lead

institution and participants in the event that more than

one loan to the borrower defaults; and

• Provisions for terminating the agency relationship

between the lead and participating banks upon such

events as insolvency, breach of duty, negligence, or

misappropriation by one of the parties.

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

comply with Section 23A of the Federal Reserve Act. The

Federal Reserve Board’s staff has interpreted that the

purchase of a participation loan from an affiliate is exempt

from Section 23A provided that the commitment to

purchase is obtained by the affiliate before the loan is

consummated by the affiliate, and the decision to participate

is based upon the institution'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 Percent Loan Participations

In some cases, depository institutions structure loan

originations and participations with the intention of selling

100 percent of the underlying loan amount. Certain 100

percent loan participation programs raise unique safety and

soundness issues that should be addressed by an

institution’s policies, procedures, and practices.

If not appropriately structured, these 100 percent

participation programs can present unwarranted risks to the

originating institution including legal, and compliance risks.

Therefore, agreements to mitigate these risks clearly state

the limitations the originating and participating institutions

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impose on each other and the rights all parties retain. This

typically includes the originating institution stating that loan

participants are participating in loans and are not investing

in a business enterprise. The policies of an institution

engaged in these originations typically address safety and

soundness concerns and include criteria to address:

• The program’s objectives – these should be of a

commercial nature (structured as commercial

undertakings and not as investments in securities).

• The plan of distribution – participants should be

limited to sophisticated financial and commercial

entities and sophisticated persons and the

participations should not be sold directly to the public.

• The credit requirements applicable to the borrower -

the originating institution should structure 100% loan

participation programs only for borrowers who meet

the originating institution’s credit requirements.

• Access afforded program participants to financial

information on the borrower - the originating

institution should allow potential loan participants to

obtain and review appropriate credit and other

information to enable the participants to make an

informed credit decision.

Environmental Risk Program

The potential adverse effect of environmental

contamination on the value of real property and the potential

for liability under various environmental laws are important

factors for institution management to consider in evaluating

real estate transactions and making loans secured by real

estate. Institutions that establish appropriate environmental

risk programs lower their potential liability for certain types

of environmental risks and penalties per the Comprehensive

Environmental Response, Compensation and Liability Act

of 1980 (CERCLA).

An appropriate environmental risk program is consistent

with the safety and soundness standards prescribed in

Appendix A to Part 364 of the FDIC Rules and Regulations.

The environmental risk program enables institution

management to make an informed lending decision and to

assess risk, as necessary, and helps provide for

consideration of the nature and value of any underlying

collateral. Such a program also is consistent with the real

estate lending standards prescribed in Part 365 of the

FDIC’s Rules and Regulations relating to compliance with

all real estate related laws and regulations, which include

the CERCLA.

See CERCLA, as amended by the Superfund Amendments and

Reauthorization Act of 1986, 42 U.S.C. §§ 9601 et seq., the Resource

Conservation and Recovery Act of 1976, as amended, 42 U.S.C. §§ 6901

Thus, examiners should verify that institutions maintain an

environmental risk program to evaluate the potential

adverse effect of environmental contamination on the value

of real property and the potential environmental liability

associated with the real property. An effective

environmental risk program aids management’s decision-

making process by establishing procedures for identifying

and evaluating potential environmental concerns associated

with lending practices and other actions relating to real

property.

Examiners should determine whether the board of directors

reviews and approves the program periodically and

designates a senior officer knowledgeable in environmental

matters to be responsible for program implementation.

Examiners should assess whether the environmental risk

program is commensurate with the institution’s operations.

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. For

example, loans collateralized by 1- to 4-family residences

normally have less exposure to environmental liability than

loans to finance industrial properties.

Elements of an Effective Environmental Risk Program

The environmental risk program typically provides for staff

training, sets environmental policy guidelines and

procedures, requires an environmental review or analysis

during the application or due diligence process, includes

loan documentation standards, and establishes appropriate

environmental risk assessment safeguards in loan workout

situations and foreclosures.

Training

The environmental risk program generally incorporates

training sufficient to ensure that the environmental risk

program is implemented and followed, and that the

appropriate personnel have the knowledge and experience

to identify and evaluate potential environmental concerns

that might affect the institution, including its interests in real

property. Such training programs typically address

circumstances where the complexity of the environmental

issue is beyond the expertise of the institution’s staff to

adequately assess by instructing staff to consult legal

counsel, environmental consultants, or other qualified

experts.

et seq., and the Asset Conservation, Lender Liability, and Deposit

Insurance Protection Act of 1996 (Asset Conservation Act).

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Policies

Loan policies and written procedures typically address

environmental issues pertinent to the institution’s specific

lending activities. For example, the lending policy may

identify the types of environmental risks associated with

industries and real estate in the institution’s trade area,

provide guidelines for conducting an analysis of potential

environmental liability, and describe procedures for the

resolution of potential environmental concerns. Procedures

for the resolution of environmental concerns might also be

developed for credit monitoring, loan workout situations,

and foreclosures.

Environmental Risk Analysis

Examiners should determine whether management

conducts an initial environmental risk analysis during the

application process prior to making a loan. An appropriate

analysis helps management to minimize potential

environmental liability and facilitates implementation of

appropriate mitigation strategies prior to closing a loan.

Much of the needed information may be gathered by the

account officer when interviewing the loan applicant

concerning his or her business activities. Some institutions

use the loan application to request relevant environmental

information, such as the present and past uses of the

property and the occurrence of any contacts by federal, state

or local governmental agencies about environmental

matters. For some transactions, the loan officer or other

representative of an institution may visit the site to evaluate

whether there is obvious visual evidence of environmental

concerns; such visits are usually documented in the loan

file.

Structured Environmental Risk Assessment

Whenever the application, interview, or visitation indicates

a possible environmental concern, examiners should

determine whether a more detailed structured investigation

was conducted by a qualified individual. This investigation

may include surveying prior owners of the property,

researching past uses of the property, inspecting the site and

contiguous parcels, and reviewing company records for past

use or disposal of hazardous materials. A review of public

records and contact with federal and state environmental

protection agencies often helps institution management

determine whether the borrower has been cited for

violations concerning environmental laws or if the property

has been identified on federal and state lists of real property

with significant environmental contamination. Examiners

should also determine whether the institution’s policies and

procedures consider the Environmental Protection

Agency’s (EPA) “All Appropriate Inquiry Rule.”

EPA All Appropriate Inquiry Rule – I

n January 2002,

Congress amended the CERCLA to establish, among

other things, additional protections from cleanup

liability for a new owner of a property. The bona fide

prospective purchaser provision establishes that a

person may purchase property with the knowledge that

the property is contaminated without being held

potentially liable for the cleanup of contamination at

the property.

he new owner must meet certain statutory

requirements to qualify as a bona fide prospective

purchaser and, prior to the date of acquiring the

property, undertake “all appropriate inquiries” into the

prior ownership and uses of the property.

In November 2005, the EPA promulgated its

“Standards and Practices for All Appropriate Inquiries”

final rule (EPA All Appropriate Inquiry Rule) which

establishes the standards and practices that are

necessary to meet the requirements for an “all

appropriate inquiry” into the prior ownership and uses

of a property. The All Appropriate Inquiry Rule

became effective on November 1, 2006.

An environmental evaluation of the property that meets

the standards and practices of the EPA All Appropriate

Inquiry Rule will provide the borrower with added

protection from CERCLA cleanup liability, provided

the borrower meets the requirements to be a bona fide

purchaser and other statutory requirements. This

protection, however, is limited to CERCLA and does

not apply to the Resource Compensation and Recovery

Act (RCRA), including liability associated with

underground storage tanks, and other federal

environmental statutes, and, depending on state law,

state environmental statutes. In addition, such an

environmental evaluation may provide a more detailed

assessment of the property than an evaluation that does

not conform to the EPA All Appropriate Inquiry Rule.

Examiners should determine whether, as part of its

environmental risk analysis of any particular extension

of credit, a lender evaluates whether it is appropriate or

necessary to require the borrower to perform an

environmental evaluation that meets the standards and

practices of the EPA All Appropriate Inquiry Rule.

This decision involves judgment and is made on a case-

by-case basis considering the risk characteristics of the

transaction, the type of property, and the environmental

information gained during an initial environmental risk

analysis. If indications of environmental concern are

known or discovered during the loan application

process, an institution may decide to require the

borrower to perform an environmental evaluation that

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meets the requirements of the EPA All Appropriate

Inquiry Rule.

he decision to require the borrower to perform a

property assessment that meets the requirements of the

EPA All Appropriate Inquiry Rule is generally made in

the context of the institution’s environmental risk

program. An effective environmental risk program is

generally designed to ensure management makes an

informed judgment about potential environmental risk

and considers such risks in its overall consideration of

risks associated with the extension of credit. In

addition, an institution’s environmental risk program

may be tailored to its lending practices. Thus, a lender

makes its decision concerning when and under what

circumstances to require the borrower to perform an

environmental property assessment based on its

environmental risk program. Individuals who

administer an institution’s environmental risk program

are typically familiar with these statutory elements.

More information concerning the EPA All Appropriate

Rule can be found on the EPA website at

http://www.epa.gov/brownfields/regneg.htm

onitoring

xaminers should assess whether the environmental risk

assessment continues during the life of the loan, including

monitoring the borrower and the real property collateral for

potential environmental concerns. Examiners should assess

whether loan officers are aware of changes in the business

activities of a borrower that may result in a significant

increase in risk of environmental liability associated with

real property collateral. When there is a potential for

environmental contamination to adversely affect the value

of the collateral, management might exercise its rights under

the loan covenants to require the borrower to resolve the

environmental condition and to take actions to protect the

value of the real property.

Loan Documentation

Loan documents typically include language to safeguard the

institution against potential environmental losses and

liabilities. Such language might require that the borrower

comply with environmental laws, disclose information

about the environmental status of the real property

collateral, and grant the institution the right to acquire

additional information about potential hazardous

contamination by inspecting the collateral property for

environmental concerns. The loan documents might also

provide the institution the right to call the loan, refuse to

extend funds under a line of credit, or foreclose if hazardous

contamination is discovered. The loan documents might

also call for an indemnity of the institution by the borrower

and guarantors for environmental liability associated with

the real property collateral.

Involvement in the Borrower’s Operations

nder CERCLA and many state environmental cleanup

statutes, an institution may have an exemption from

environmental liability as the holder of a security interest in

real property collateral. Examiners should determine

whether institution management, in monitoring a loan, takes

action to resolve environmental situations and evaluates

whether its actions may constitute “participating in the

management” of the business located on the real property

collateral within the meaning of CERCLA. If its actions are

considered participation in the management, the institution

may lose its exemption from liability under CERCLA or

similar state statutes.

oreclosure

A lender’s exposure to environmental liability may increase

significantly if it takes title to real property held as

collateral. Examiners should determine whether

management evaluates the potential costs and liability for

environmental contamination in conjunction with an

assessment of the value of the collateral in reaching a

decision to take title to the property by foreclosure or other

means. Based on the type of property involved, a lender

often includes as part of this evaluation of potential

environmental liability, an assessment of the property that

meets the requirements of the EPA All Appropriate Inquiry

Rule.

xamination Procedures

xaminers should review an institution’s environmental

risk program as part of the examination of lending and

investment activities. When analyzing individual credits,

examiners should review the institution’s compliance with

its environmental risk program. Failure to establish or

comply with an appropriate environmental program is to be

criticized.

←

LOAN PROBLEMS

t would be impossible to list all sources and causes of

problem loans. They cover a multitude of mistakes an

institution may permit a borrower to make, as well as

mistakes directly attributable to weaknesses in the

institution's credit administration and management. Some

well-constructed loans may develop problems due to

unforeseen circumstances on the part of the borrower;

however, institution management must endeavor to protect

a loan by every means possible. One or more of the items

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in the following list is often basic to the development of loan

problems.

Many of these items may also be indicative of potential

institution 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.

Poor Selection of Risks

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.

• Loans to finance new and untried business ventures

which are inadequately capitalized.

• Loans based more upon the expectation of

successfully completing a business transaction than on

sound worth or collateral.

• Loans for the speculative purchase of securities or

goods.

• Collateral loans made without adequate margin of

security.

• Loans made because of other benefits, such as the

control of large deposit balances, and not based upon

sound worth or collateral.

• Loans made without adequate owner equity in

underlying real estate security.

• Loans predicated on collateral which has questionable

liquidation value.

• Loans predicated on the unmarketable stock of a local

corporation when the institution is at the same time

lending directly to the corporation. Action which may

be beneficial to the institution from the standpoint of

the one loan may be detrimental from the standpoint

of the other loan.

• Loans which appear to be adequately protected by

collateral or sound worth, but which involve a

borrower of poor character risk and credit reputation.

• Loans which appear to be adequately protected by

collateral, but which involve a borrower with limited

or unassessed repayment ability.

• An abnormal amount of loans involving

out-of-territory borrowers (excluding large banks

properly staffed to handle such loans).

• Loans involving brokered deposits or link financing.

Overlending

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.

Failure to Establish or Enforce Liquidation

Agreements

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.

Incomplete Credit Information

Lending errors frequently result because of management's

failure to obtain and properly evaluate credit information.

Adequate 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 institution's credit files. Failure of an institution's

management to give proper attention to credit files makes

sound credit judgment difficult if not impossible.

Overemphasis on Loan Income

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.

Self-Dealing

Pronounced self-dealing practices are often present in

serious problem institution situations and in banks which

fail. Such practices with regard to loans are found in the

form of overextensions of unsound credit 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 at times subjected to

pressures which make it difficult to objectively evaluate

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such loans. Loans made for the benefit of ownership

interests that are carried in the name of a seemingly

unrelated party are sometimes used to conceal self-dealing

loans.

Technical Incompetence

Technical incompetence usually is manifested in

management's inability to obtain and evaluate credit

information or 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.

Lack of Supervision

Loan problems encountered in this area normally arise for

one of two reasons:

• 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.

• Failure of the board and/or senior management to

properly oversee subordinates to determine that sound

policies are being carried out.

Lack of Attention to Changing Economic

Conditions

Economic conditions, both national and local, are

continuously changing, management must be responsive to

these changes. This is not to suggest that 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 an institution'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

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.

Potential Problem Indicators by Document

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 examination process.

• Debt Instrument - Delinquency; irregular payments

or payments not in accordance with terms; unusual or

frequently modified terms; numerous renewals with

little or no principal reduction; renewals that include

interest; and extremely high interest rate in relation to

comparable loans granted by the institution or the

going rate for such loans in the institution's market

area.

• Liability Ledger - Depending on the type of debt,

failure to amortize in a regular fashion over a

reasonable period of time, e.g., on an annual basis,

seasonally, etc.; and a large number of out-of-territory

borrowers, particularly in cases where these types of

loans have increased substantially since the previous

examination.

• Financial and Operating Statements - Inadequate or

declining working capital position; excessive volume

or negative trend in receivables; unfavorable level or

negative trend in inventory; no recent aging of

receivables, or a marked slowing in receivables;

drastic increase in volume of payables; repeated and

increasing renewals of carry-over operating debt;

unfavorable trends in sales and profits; rapidly

expanding expenses; heavy debt-to-worth level and/or

deterioration in this relationship; large dividend or

other payments without adequate or reasonable

earnings retention; and net worth enhancements

resulting solely from reappraisal in the value of fixed

assets.

• Cash Flow Documentation - Absence of cash flow

statements or projections, particularly as related to

newly established term borrowers; projections

indicating an inability to meet required interest and

principal payments; and statements reflecting that cash

flow is being provided by the sale of fixed assets or

nonrecurring situations.

• Correspondence and Credit Files - Missing and/or

inadequate collateral or loan documentation, such as

financial statements, security agreements, guarantees,

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assignments, hypothecation agreements, mortgages,

appraisals, legal opinions and title insurance, property

insurance, loan applications; evidence of borrower

credit checks; corporate or partnership borrowing

authorizations; letters indicating that a borrower has

suffered financial difficulties or has been unable to

meet established repayment programs; and documents

that reveal other unfavorable factors relative to a line

of credit.

• Collateral - Collateral evidencing a speculative loan

purpose or collateral with inferior marketability

characteristics (single purpose real estate, restricted

stock, etc.) which has not been compensated for by

other reliable repayment sources; and collateral of

questionable value acquired subsequent to the

extension of the credit.

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SELECTING A LOAN REVIEW SAMPLE

IN A RISK-FOCUSED EXAMINATION

Examiners are expected to select a sample of loans that is of

sufficient size, scope, and variety to enable them to reach

reliable conclusions about the aforementioned aspects of an

institution’s overall lending function, and tailor the loan

review sample based on an institution’s business model,

complexity, risk profile, and lending activities. The review

may include all sources of credit exposure arising from

loans and leases, including guarantees, letters of credit, and

other commitments.

Assessing the Risk Profile

Prior to developing the loan review sample, examiners are

to assess the risk profile of the loan portfolio by reviewing

the institution’s management reports and policies as well as

agency available information. This includes evaluating

concerns detailed in prior Reports of Examination (ROEs),

issues detailed in the institution’s loan exception reports and

internal loan reviews, and the historical accuracy of

independent credit rating or grading systems. The Uniform

Bank Performance Report provides information relative to

loan mix and recent trends, such as concentrations of credit,

rapid growth, and loan yields higher or lower than peer in

different portfolio segments. Examiners are also to consider

changes in local economic or market conditions that could

affect the portfolio’s risk profile. Numerous economic tools

and resources are available to examiners to assist in

planning the loan review.

As part of the examination planning activities, examiners

are to consider whether management has implemented any

material changes in the institution’s business lines, loan

products, lending policies, markets, or personnel since the

prior examination. Additionally, examiners should consider

whether activities conducted by a branch, subsidiary,

affiliate, or third party partner warrant particular attention.

Examiners are to consider the historical adequacy of the

institution’s policies and practices relative to credit

underwriting, administration, and loan grading for each

significant loan type. Examiners should review recent

management reports and Board or committee packages

before selecting a targeted sample to determine whether the

Board of Directors and officers are receiving sufficient

information to remain abreast of emerging trends and

changes in the loan portfolio’s risk profile.

Selecting the Sample

The size and composition of the loan sample should be

commensurate with the quantity of credit risk, the adequacy

of risk management practices, and the institution’s financial

condition and business model. There are no established or

expected levels of minimum or maximum coverage, or

penetration, ratios for loan review samples. Rather,

examiners should use judgment when determining the focus

and extent of loan sampling. Ensuring that the appropriate

types of loans are in the sample is more meaningful than

how much of the overall portfolio is reviewed.

Examiners must make the most efficient use of resources,

and should sample loans of sufficient size, scope and variety

to enable them to form reliable conclusions about overall

credit quality and the adequacy of credit risk management

and governance. Examiners’ understanding of the

institution’s business model, risk profile, complexity,

external and internal reports, as well as discussions with

management, will be highly instrumental in identifying

loans to be included in a judgmental sample. Examiners

may also leverage the institution’s external and internal loan

reviews when determining the loan sample. For example,

examiners may want to exclude loans already covered in

institution loan reviews or follow-up on loans identified as

problems in the loan reviews.

If information gathered indicates weaknesses in

underwriting or credit administration practices, or if the

institution is engaging in lending activities with significant

or increasing risk, the examiner should select a robust

sample to fully assess the risk areas. Conversely,

institutions with stable, well-managed loan functions

exhibiting few signs of change should have more

streamlined reviews, focusing more on newer originations

and less on loans that were deemed of satisfactory quality at

previous examinations that continue to perform as agreed.

However, in all instances, examiners should sample enough

credits, including new and various-sized credits, to assess

the adequacy of asset quality, underwriting practices, and

credit risk management, in order to support ROE findings

and assigned ratings.

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Nonhomogeneous Loan Sample

Nonhomogeneous loans include acquisition, development

and construction, commercial real estate, commercial and

industrial, and agricultural credits. The nonhomogeneous

loan sample generally should include a sufficient number of

loans to transaction test various segments of the loan

portfolio, but it is unnecessary to review all loans in a

particular segment. Rather, the loan review should

encompass enough loans in each portfolio segment to

support examination conclusions about credit quality and

credit management practices relative to underwriting

standards and credit administration.

In general, a sampling of loans in the following segments

should be included in the overall loan review sample, as

applicable to a particular institution:

• Adversely classified or listed for Special Mention in

prior ROEs.

• Delinquent, nonaccrual, impaired, or

renegotiated/restructured (particularly loans with

multiple renewals).

• Internally adversely classified by the institution.

• Rated by the institution as a marginally acceptable

credit.

• Subject to prior supervisory criticism or corrective

actions.

• Upgraded or removed from internal adverse

classification since the prior examination, to ensure

that procedures for managing the watch list are

appropriate.

• Insider loans (directors, officers, employees, principal

shareholders, or related interests at any insured

depository institution).

• Originated since the prior examination, including

those in new or expanding product lines.

• Participations.

• Out of territory.

• Part of a significant credit concentration or growth

area.

• Flagged for potential fraud.

• Contain outlier characteristics (e.g. higher risk loans,

credits with policy exceptions).

• Originated by specific loan officers, particularly those

with known concerns or weaknesses.

• In geographic areas exposed to changes in market

conditions.

• Various sized loans (larger, mid-sized, and smaller

loan amounts).

As part of a risk-focused and forward-looking approach to

loan review, loans that had been reviewed at previous

examinations that had sufficient performance, collateral and

documentation, and continue to amortize as agreed, may be

more appropriate for Discuss Only or not included at all,

which would allow more resources to be focused on new

originations or other loans not previously reviewed that

would help evaluate areas of significant or growing risk.

Homogeneous Pool Sample

Assessing the quality of homogeneous retail consumer

credit on a loan-by-loan basis is burdensome for both

institutions and examiners due to portfolios generally

consisting of a large number of loans with relatively low

balances. Instead, examiners should assess the quality of

retail consumer loans based on the borrowers’ repayment

performance. Examiners generally should review and

classify retail consumer loans in accordance with the

procedures discussed later in this section under the

Interagency Retail Credit Classification Policy subheading.

The EIC may supplement the classification of retail loans

with a direct review of larger consumer loans or by sampling

various segments when the risk assessment supports doing

so. Such an expansion may be warranted when

homogeneous lending is a major business line of the

institution or when examiners note rapid growth, new

products, weaknesses in the loan review or audit program,

weaknesses in management information systems, or other

factors that raise concerns. The EIC also may conduct

limited transaction testing to focus on specific risk

characteristics, such as the underwriting standards for new

loans or the revised terms granted in workouts or

modifications.

Sampling for Trading and Derivatives Activities. At

institutions that are active in such markets, examiners

should include an assessment of credit exposures arising

from matching loans with derivatives (generally swaps or

forwards) to hedge a particular type of risk. For example,

an institution can use a swap to contractually exchange a

stream of floating-rate payments for a stream of fixed-rate

payments to hedge interest rate risk. Such activities create

a credit exposure relative to both the loan and the derivative.

When warranted, examiners should review a sufficient

number of loan relationships with these exposures to assess

the institution’s overall exposure and management’s ability

to prudently manage derivatives activities. Examiners also

should review a sample of credit relationships established

solely for the purpose of facilitating derivatives activities.

Determining the Depth of the Review

Examiners should assign loans to be reviewed into one of

three groupings, “In Scope” (full review), “Discuss Only”

(limited review), and, when applicable, “Group” (pooled

loans).

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In Scope. This sample consists of loans that warrant the

most comprehensive level of review. Examiners are to

review loan files to the extent needed to assess the risk in

the credit, conformance to lending risk management

policies and procedures, and compliance with applicable

laws and regulations. Examiners should document the

assessment of the borrower’s repayment capacity, collateral

protection, and overall risk to the institution on individual

linesheets. Documentation should also note underwriting

exceptions, administrative weaknesses, and apparent

violations.

For institutions with stable, well-managed loan functions, In

Scope loans should generally focus on newer originations

and insider loans. In these situations, if certain loans from

previous examinations are included In Scope, examiners

have the ability to leverage documentation from previous

reviews and focus on updates to the essential credit

information.

Discuss Only. This sample is to consist of loans subject to

a limited level of review, and examiners are to discuss these

credits with institution management. Such discussions can

be an effective method of confirming the adequacy of loan

grading systems and credit administration practices,

particularly when the In Scope sample indicates the

institution has adequate risk management practices, and

when the institution has a stable, well-managed loan

function and exhibits few signs of change. Examiners

should briefly document key issues raised during these

discussions, but examiners do not need to complete full

linesheets. When warranted, examiners may conduct a

limited file review or assessment of specific work-out plans

and performance metrics for these loans.

Credits should be reallocated from Discuss Only to In Scope

if management disagrees with the classification, material

concerns with credit underwriting or administration

practices are identified, or the EIC or Asset Manager

determines a more comprehensive review is warranted.

Group. This sample could include loans with similar risk

characteristics that merit review on a pooled

basis. Examiners generally should discuss or classify the

loans not on an individual basis but as a pool, and apply the

findings and conclusions to the entire Group. Examiners

may use multiple Groups to focus on the adequacy of credit

underwriting and administration practices or to address

different risk attributes in stratified segments. The Group

sample may be appropriate for specific categories of

homogeneous retail consumer credit, such as automobile,

credit card, or residential mortgage loans.

Adjusting Loan Review

The EIC has the flexibility, after communicating with the

case manager and receiving concurrence of field

management, to adjust the loan review sample at any point

during the examination based on findings. The rationale for

significant changes in the examination plan will be clearly

communicated to institution management, along with any

adjustments to the breadth or depth of procedures,

personnel, and examination schedule.

Accepting an Institution’s Internal Ratings

If the institution’s internal grading system (watch list) 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.

Loan Penetration Ratio

The FDIC has not established any minimum or maximum

loan penetration ratios.

The objectives for loan review on an examination include

an analysis of credit quality through transaction testing and

an assessment of credit administration practices. Achieving

a specific loan penetration ratio is not to be the driving

factor in determining the loan review sample. Rather,

examiners should focus on reviewing a sufficient number of

loans in various segments of the portfolio to assess overall

risk in the portfolio and to support examination findings,

and then calculate the resultant loan penetration ratio for

informational purposes only and enter the ratio in the

Summary Analysis of Examination Report.

Large Bank Loan Review

In addition to point-in-time examinations conducted at most

community banks, the FDIC utilizes targeted loan reviews

conducted under a supervisory plan, guiding a continuous

examination program for certain institutions. These

targeted programs are generally warranted to ensure

effective monitoring and examination activity related to

larger and more complex institutions. While the

supervisory plan and continuous examination processes and

procedures may differ in some respects from the point in

time approach, the principles contained in the preceding

loan review instructions are applicable to examination

activities for all institutions supervised by the FDIC.

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LOAN EVALUATION AND

CLASSIFICATION

Loan Evaluation

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 type and sophistication of records

utilized by the institution.

Review of Files and Records

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 institution, 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 institution 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 institution 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 institution'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 institution

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 ED Modules.

Additional Transaction Testing

Part of the assessment of loan administration practices

includes transaction testing. Such testing can verify that the

institution’s written policies and practices are implemented

as intended. Testing can also be useful in detecting potential

fraudulent or irregular activity. In particular, examiners are

required to verify a sample of loans that paid off during or

just prior to the on-site portion of the examination. Such

verification would include reviewing the loan file, payoff

tickets, and tracing the source of funds for the payoff.

Loan Discussion

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, eliminating the need for discussing these lines

with the appropriate institution officer(s). No matter how

thoroughly the 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 institution 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.

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Loan Analysis

In the evaluation 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 a loan’s risk. 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 institution's senior management

and/or the directorate and in the Report of Examination.

Loan Classification

To quantify and communicate the results of the loan review,

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: Substandard;

Doubtful; and Loss.

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 institution'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.

The Uniform Agreement on the Classification and

Appraisal of Securities Held by Depository Institutions was

issued on October 29, 2013, by the Office of the

Comptroller of the Currency, the FDIC, and the Federal

Reserve Board. The attachment to this interagency

statement provides definitions of Substandard, Doubtful,

and Loss categories used for adversely classifying

institution assets. Amounts classified Loss should be

promptly eliminated from the institution's books.

Uniform guidelines have been established by the FDIC

regarding the Report of Exam treatment of assets classified

Doubtful. The general policy is not to require charge-off or

similar action for Doubtful classifications. Examiners

should make a statement calling for an institution 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 the intended purpose of bringing the

institution 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 Report of Examination when

the amount is material. Amounts classified Loss should be

promptly eliminated from the institution's books.

Definitions

• 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 institution will sustain

some loss if the deficiencies are not corrected.

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• 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.

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, if

unimproved, may be a future hazard.

A complete list of adversely classified loans is to be

provided to management, either during or at the close of an

examination.

Special Mention Assets

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.

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.

Ordinarily, Special Mention credits have characteristics

which corrective management action would remedy. Often

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

loan portfolio and providing constructive criticism for

institution management. While Special Mention Assets

should not be combined with adversely classified assets,

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 towards achieving

correction of the deficiencies identified.

Technical Exceptions

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,

an excessive number of technical exceptions may be 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.

Past Due and Nonaccrual

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 institution 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

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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: 30 to 89 days past due and 90 days or

more 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 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 institution's renewal and

extension policies and procedures for collecting interest

prior to determining which loans are overdue, since such

practices often vary considerably from institution to

institution. 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 exist. The production of schedules delineating

overdue loans by department or branch is encouraged if it

will aid in pinpointing the source of a problem or be

otherwise informative.

Continuing to accrue income on assets which are in default

as to principal and interest overstates an institution's assets,

earnings, and capital. Call Report Instructions indicate 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. 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. Institutions are strongly encouraged 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 institution'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.

Nonaccrual Loans That Have Demonstrated

Sustained Contractual Performance

The following information 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 a prior arrearage may

not have been eliminated by payments from a borrower, the

borrower may have demonstrated sustained performance

over a period of time in accordance with the contractual

terms. Such loans to be returned to accrual status, even

though the loans have not been brought fully current,

provided two criteria are met:

• All principal and interest amounts contractually due

(including arrearage) are reasonably assured of

repayment within a reasonable period, and

• There is a sustained period of repayment performance

(generally a minimum of six months) by the borrower,

in accordance with the contractual terms involving

payments of cash or cash equivalents.

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.

Troubled Debt Restructuring - Multiple Note

Structure

The basic example of a trouble debt restructuring (TDR)

multiple note structure is a troubled loan that is restructured

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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. 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). For other TDRs, the

"B" note may be contingently forgiven (e.g., note "B" is

forgiven if note "A" is paid in full). 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:

• The restructuring qualifies as a TDR as defined by

ASC Subtopic 310-40, Receivables – Troubled Debt

Restructurings by Creditors and there is economic

substance to the restructuring.

• The portion of the original loan represented by the "B"

note has been charged-off. The charge-off must be

supported by a current, well-documented credit

evaluation of the borrower's financial condition and

prospects for repayment under the revised terms. The

charge-off must be recorded before or at the time of

the restructuring.

• The "A" note is reasonably assured of repayment and

of performance in accordance with the modified

terms.

• In general, the borrower must have demonstrated

sustained repayment performance (either immediately

before or after the restructuring) in accordance with

the modified terms for a reasonable period prior to the

date on which the "A" note is returned to accrual

status. A sustained period of payment performance

generally would be a minimum of six months and

involve payments in the form of cash or cash

equivalents.

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.

Interagency Retail Credit Classification

Policy

The quality of consumer credit soundness is best indicated

by the repayment performance demonstrated by the

borrower. Because retail credit generally is comprised of a

large number of relatively small balance loans, evaluating

the quality of the retail credit portfolio on a loan-by-loan

basis is burdensome for the institution being examined and

examiners. To promote an efficient and consistent credit

risk evaluation, the FDIC, the Comptroller of Currency, the

Federal Reserve and the former Office of Thrift Supervision

adopted the Uniform Retail Credit Classification and

Account Management Policy (Retail Classification Policy.)

Retail credit includes open-end and closed-end credit

extended to individuals for household, family, and other

personal expenditures. It includes consumer loans and

credit cards. For purposes of the policy, retail credit also

includes loans to individuals secured by their personal

residence, including home equity and home improvement

loans.

In general, retail credit should be classified based on the

following criteria:

• Open-end and closed-end retail loans past due 90

cumulative days from the contractual due date should

be classified Substandard.

• Closed-end retail loans that become past due 120

cumulative days and open-end retail loans that

become past due 180 cumulative days from the

contractual due date should be charged-off. The

charge-off should be taken by the end of the month in

which the 120-or 180-day time period elapses.

• Unless the institution can clearly demonstrate and

document that repayment on accounts in bankruptcy is

likely to occur, accounts in bankruptcy should be

charged off within 60 days of receipt of notification of

filing from the bankruptcy court or within the

delinquency time frames specified in this

classification policy, whichever is shorter. The

charge-off should be taken by the end of the month in

which the applicable time period elapses. Any loan

balance not charged-off should be classified

Substandard until the borrower re-establishes the

ability and willingness to repay (with demonstrated

payment performance for six months at a minimum)

or there is a receipt of proceeds from liquidation of

collateral.

• Fraudulent loans should be charged off within 90 days

of discovery or within the delinquency time frames

specified in this classification policy, whichever is

shorter. The charge-off should be taken by the end of

the month in which the applicable time period elapses.

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• Loans of deceased persons should be charged off

when the loss is determined or within the delinquency

time frames adopted in this classification policy,

whichever is shorter. The charge-off should be taken

by the end of the month in which the applicable time

period elapses.

• One-to-four family residential real estate loans and

home equity loans that are delinquent 90 days or more

with loan-to-value ratios greater than 60 percent,

should be classified Substandard.

When an open- or closed-end residential or home equity

loan is 180 days past due, a current assessment of value

should be made and any outstanding loan balance in excess

of the fair value of the property, less cost to sell, should be

classified Loss.

Properly secured residential real estate loans with loan-to-

value ratios equal to or less than 60 percent are generally not

classified based solely on delinquency status. Home equity

loans to the same borrower at the same institution as the

senior mortgage loan with a combined loan-to-value ratio

equal to or less than 60 percent should not be classified.

However, home equity loans where the institution does not

hold the senior mortgage, that are delinquent 90 days or

more should be classified Substandard, even if the loan-to-

value ratio is equal to, or less than, 60 percent.

If an institution can clearly document that the delinquent

loan is well secured and in the process of collection, such

that collection will occur regardless of delinquency status,

then the loan need not be classified. A well secured loan is

collateralized by a perfected security interest in, or pledges

of, real or personal property, including securities, with an

estimated fair value, less cost to sell, sufficient to recover

the recorded investment in the loan, as well as a reasonable

return on that amount. In the process of collection means

that either a collection effort or legal action is proceeding

and is reasonably expected to result in recovery of the loan

balance or its restoration to a current status, generally within

the next 90 days.

This policy does not preclude an institution from adopting

an internal classification policy more conservative than the

one detailed above. It also does not preclude a regulatory

agency from using the Doubtful or Loss classification in

certain situations if a rating more severe than Substandard

is justified. Loss in retail credit should be recognized when

the institution becomes aware of the loss, but in no case

should the charge-off exceed the time frames stated in this

policy.

Re-aging, Extensions, Deferrals, Renewals, or Rewrites

Re-aging is the practice of bringing a delinquent account

current after the borrower has demonstrated a renewed

willingness and ability to repay the loan by making some,

but not all, past due payments. Re-aging of open-end

accounts, or extensions, deferrals, renewals, or rewrites of

closed-end accounts should only be used to help borrowers

overcome temporary financial difficulties, such as loss of

job, medical emergency, or change in family circumstances

like loss of a family member. A permissive policy on re-

agings, extensions, deferrals, renewals, or rewrites can

cloud the true performance and delinquency status of the

portfolio. However, prudent use of a policy is acceptable

when it is based on recent, satisfactory performance and the

true improvement in a borrower's other credit factors, and

when it is structured in accordance with internal policies.

The decision to re-age a loan, like any other modification of

contractual terms, should be supported in the institution's

management information systems. Adequate management

information systems usually identify and document any loan

that is extended, deferred, renewed, or rewritten, including

the number of times such action has been taken.

Documentation normally shows that institution personnel

communicated with the borrower, the borrower agreed to

pay the loan in full, and the borrower shows the ability to

repay the loan.

Institutions that re-age open-end accounts should establish

a reasonable written policy and adhere to it. An account

eligible for re-aging, extension, deferral, renewal, or rewrite

should exhibit the following:

• The borrower should show a renewed willingness and

ability to repay the loan.

• The account should exist for at least nine months

before allowing a re-aging, extension, renewal,

referral, or rewrite.

• The borrower should make at least three minimum

consecutive monthly payments or the equivalent lump

sum payment before an account is re-aged. Funds

may not be advanced by the institution for this

purpose.

• No loan should be re-aged, extended, deferred,

renewed, or rewritten more than once within any

twelve-month period; that is, at least twelve months

must have elapsed since a prior re-aging. In addition,

no loan should be re-aged, extended, deferred,

renewed, or rewritten more than two times within any

five-year period.

• For open-end credit, an over limit account may be re-

aged at its outstanding balance (including the over

limit balance, interest, and fees). No new credit may

be extended to the borrower until the balance falls

below the designated predelinquency credit limit.

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Partial Payments on Open-End and Closed-End Credit

Institutions should use one of two methods to recognize

partial payments. A payment equivalent to 90 percent or

more of the contractual payment may be considered a full

payment in computing delinquency. Alternatively, the

institution may aggregate payments and give credit for any

partial payment received. For example, if a regular

installment payment is $300 and the borrower makes

payments of only $150 per month for a six-month period,

the loan would be $900, or three full months delinquent. An

institution may use either or both methods in its portfolio,

but may not use both methods simultaneously with a single

loan.

Examination Considerations

Examiners should determine whether institutions’ policies

and practices consider the Retail Classification Policy,

understanding that there may be instances that warrant

exceptions to the general classification policy. Loans need

not be classified if the institution can document clearly that

repayment will occur regardless of delinquency status.

Examples might include loans well secured by marketable

collateral and in the process of collection, loans for which

claims are filed against solvent estates, and loans supported

by valid insurance claims. Conversely, the Retail

Classification Policy does not preclude examiners from

reviewing and classifying individual large dollar retail

credit loans that exhibit signs of credit weakness regardless

of delinquency status.

In addition to reviewing loan classifications, the examiner

should review the ALLL to assess whether it is at an

appropriate level. Sound risk and account management

systems typically include:

• Prudent retail credit lending policies,

• Measures to monitor adherence to policy,

• Detailed operating procedures, and

• Appropriate internal controls.

Institutions lacking sound policies or failing to implement

or effectively follow established policies will be subject to

criticism.

Examination Treatment

Use of the formula classification approach can result in

numerous small dollar adversely classified items. Although

these classification details are not always included in the

Report of Examination, an itemized list is to be left with

management. A copy of the listing should also be retained

in the examination work papers.

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

installment credit departments. It is important for the

examiner to give consideration to the amount and severity

of installment loan charge-offs when 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 installment

loan operation. The examiner should be alert also to the

absence of installment loan charge-offs, which may indicate

that losses are being deferred or concealed 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 institution 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

installment loan departments should receive individual

review and, in all cases, the applicable unearned income

discount should be deducted when such loans are classified.

Impaired Loans, Troubled Debt

Restructurings, Foreclosures, and

Repossessions

Loan Impairment – The accounting standard for impaired

loans is ASC Subtopic 310-10. A loan is impaired when,

based on current information and events, it is probable that

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an institution will be unable to collect all amounts due

according to the contractual terms of the loan agreement

(i.e., principal and interest). Impaired loans encompass all

loans that are restructured in a troubled debt restructuring,

including smaller balance homogenous loans that are

typically exempt from ASC Subtopic 310-10. However, the

standard does not include loans that are measured at fair

value or the lower of cost or fair value.

When a loan is impaired under ASC Subtopic 310-10, the

amount of impairment should be measured based on the

present value of expected future cash flows discounted at

the loan’s effective interest rate (i.e., the contractual interest

rate adjusted for any net deferred loan fees or costs and

premium or discount existing at the origination or

acquisition of the loan). As a practical expedient,

impairment may also be measured based on a loan’s

observable market price. The fair value of the collateral

must be used if the loan is collateral dependent. An

impaired loan is collateral dependent if repayment would be

expected to be provided solely by the sale or continued

operation of the underlying collateral.

If the measure of a loan calculated in accordance with ASC

Subtopic 310-10 is less than the recorded investment in the

loan (typically the face amount of the loan, plus accrued

interest, adjusted for any premium or discount, deferred fee

or cost, less any charge-offs), impairment on that loan

should be recognized as a part of the ALLL. In general,

when the amount of the recorded investment in the loan

exceeds the amount calculated under ASC Subtopic 310-10

and that amount is determined to be uncollectible, this

excess amount should be promptly charged-off against the

ALLL. In all cases, when an impaired loan is collateral

dependent and the repayment of the loan is expected from

the sale of the collateral, any portion of the recorded

investment in the loan in excess of the fair value less cost to

sell of the collateral should be charged-off.

Troubled Debt Restructuring - The accounting for TDRs

is set forth in ASC Subtopic 310-40, Receivables-Troubled

Debt Restructurings by Creditors. A restructuring

constitutes a troubled debt restructuring if the institution for

economic or legal reasons related to the borrower’s

financial difficulties grants a concession to the borrower

that it would not otherwise consider. A troubled debt

restructuring takes place when an institution grants a

concession to a debtor in financial difficulty. Examiners are

expected to reflect all TDRs in examination reports in

accordance with this accounting guidance and institutions

are expected to follow these principles when filing the Call

Report.

TDRs may be divided into two broad groups: those where

the borrower transfers assets to the creditor in full or partial

satisfaction of the debt, which would include foreclosures;

and those in which the terms of a debtor’s obligation are

modified, which may include reduction in the stated interest

rate to an interest rate that is less than the current market

rate for new obligations with similar risk, extension of the

maturity date, or forgiveness of principal or interest. A third

type of restructuring combines a receipt of assets and a

modification of loan terms. A loan extended or renewed at

an interest rate equal to the current market interest rate for

new debt with similar risk is not reported as a restructured

loan for examination purposes.

Transfer of Assets to the Creditor - An institution that

receives assets (except long-lived assets that will be sold)

from a borrower in full satisfaction of the recorded

investment in the loan should record those assets at fair

value. If the fair value of the assets received is less than the

institution’s recorded investment in the loan, a loss is

charged to the ALLL. When property is received in full

satisfaction of an asset other than a loan (e.g., a debt

security), the loss should be reflected in a manner consistent

with the balance sheet classification of the asset satisfied.

When long-lived assets that will be sold, such as real estate,

are received in full satisfaction of a loan, the real estate is

recorded at its fair value less cost to sell. This fair value

(less cost to sell) becomes the “cost” of the foreclosed asset.

To illustrate, assume an institution forecloses on a defaulted

mortgage loan of $100,000 and takes title to the property. If

the fair value of the property at the time of foreclosure is

$90,000 and costs to sell are estimated at $10,000, a $20,000

loss should be immediately recognized by a charge to the

ALLL. The cost of the foreclosed asset becomes $80,000.

If the institution 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 institution is willing to offer a new

mortgage loan (e.g., of $100,000) at a concessionary rate of

interest (e.g., 10 percent while the market interest rate for

new loans with similar risk is 20 percent). Before booking

this new transaction, the institution must establish its

"economic value" or what would be the cash price paid.

Pursuant to ASC Subtopic 835-30, Interest – Imputation of

Interest, 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 interest rate for this

type of credit, and the present value of the principal to be

received, also discounted at the current market interest rate.

This economic value (calculated by discounting the cash

flows at the current market interest rate) becomes the proper

carrying value for the property at its sale date. Since the

sales price of $78,000 is less than the property’s carrying

amount of $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

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resale of the property. However, the loss should be treated

as loss on the sale of real estate 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 Call Report 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. The $22,000 discount

is accreted into interest income over the life of the loan as

long as the loan remains in accrual status.

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 institution 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 institution 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.

Modification of Terms - W

hen the terms of a TDR provide

for a reduction of interest or principal, the institution should

measure any loss on the restructuring in accordance with the

guidance for impaired loans as set forth in ASC Subtopic

310-10 unless the loans are measured at fair value or the

lower of cost or fair value. The amount of impairment of

the restructured loan using the appropriate measurement

method in ASC Subtopic 310-10 is reported as a component

in determining the overall ALLL. If any amount of the

calculated impairment is determined to be uncollectible,

that amount should be promptly charged-off against the

ALLL.

or example, in lieu of foreclosure, an institution chooses to

restructure a $100,000 loan to a borrower which had

originally been granted with an interest rate of 10 percent

for 10 years. The institution and the borrower have agreed

to capitalize the accrued interest ($10,000) into the note

balance, but the restructured terms will permit the borrower

to repay the debt over 10 years at a six percent interest rate.

The institution does not believe the loan is collateral

dependent. In this situation, the institution would determine

the amount of impairment on the TDR as the difference

between the present value of the expected cash flows

discounted at the 10 percent rate specified in the original

contract and the recorded investment in loan of $110,000.

This amount of the calculated impairment becomes a

component of the overall ALLL.

Combination Approach - In some instances, the institution

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 in

the loan should be reduced by the fair value of the assets

received (less cost to sell, if appropriate). The remaining

recorded investment in the loan is accounted for as a TDR.

Examination Report Treatment - Examiners should

continue to classify TDRs, including any impaired collateral

dependent loans, based on the definitions of Loss, Doubtful,

and Substandard. When an impaired loan is collateral

dependent and the loan is expected to be satisfied by the sale

of the collateral, any portion of the recorded investment in

the loan which exceeds the fair value of the collateral, less

cost to sell is the amount of impairment included in the

ALLL. This is the amount of Loss on that loan that should

be promptly charged-off. For other loans that are impaired

loans, the amount of the recorded investment in the loan

over the amount of the calculated impairment is recognized

as a component of the ALLL. However, when available

information confirms that loans and leases (including any

recorded accrued interest, net deferred loan fees or costs,

and unamortized premium or discount) other than impaired

collateral dependent loans (dependent on the sale of the

collateral), or portions thereof, are uncollectible, these

amounts should be promptly charged-off against the ALLL.

An examiner should not require an additional allowance for

credit losses of impaired loans over and above what is

calculated in accordance with these standards. An additional

allowance on impaired loans may be supported based on

consideration of institution-specific factors, such as

historical loss experience compared with estimates of such

losses and concerns about the reliability of cash flow

estimates, the quality of an institution’s loan review

function, and controls over its process for estimating its

ASC Subtopic 310-10 allowance.

Other Considerations - Examiners may encounter

situations where impaired loans and TDRs are identified,

but the institution has not properly accounted for the

transactions. Where incorrect accounting treatment resulted

in an overstatement of earnings, capital and assets, it will be

necessary to determine the proper carrying values for these

assets, utilizing the best available information developed by

the examiner after consultation with institution

management. Nonetheless, proper accounting for impaired

loans and TDRs is the responsibility of institution

management. Examiners should not spend a

disproportionate amount of time developing the appropriate

accounting entries, but instead discuss with and require

corrective action by institution management when the

institution’s treatment is not in accordance with accepted

accounting guidelines. It must also be emphasized that

collectibility and proper accounting and reporting are

separate matters; restructuring a borrower’s debt does not

ensure collection of the loan or security. As with all other

assets, adverse classification should be assigned if analysis

indicates there is risk of loss present. Examiners should take

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care, however, not to discourage or be critical of institution

management’s legitimate and reasonable attempts to

achieve debt settlements through concessionary terms. In

many cases, restructurings offer the only realistic means for

an institution to bring about collection of weak or

nonearning assets. Finally, the volume of impaired loans

and restructured debts having concessionary interest rates

should be considered when evaluating the institution’s

earnings performance and assigning the earnings

performance rating.

Examination procedures for reviewing TDRs are included

in the ED Modules.

Report of Examination Treatment of

Classified Loans

The Items Subject to Adverse Classification page 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 page 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.

An examiner must present, in writing, relevant and readily

understandable comments related to criticized loans.

Therefore, a thorough understanding of all factors

surrounding the loan is required and only those germane to

description, collectibility, and management plans should be

included in the comments. Comments should be concise,

but brevity is not to be accomplished by omission of

appropriate 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 a Report of Examination 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 include the

following items:

• Identification - Indicate the name and occupation or

type of business of the borrower. Cosigners,

endorsers and guarantors should be identified and in

the case of business loans, it should be clear whether

the borrower is a corporation, partnership, or sole

proprietorship.

• Description - The make-up of the debt should be

concisely described as to type of loan, amount, origin

and terms. The history, purpose, and source of

repayment should also be indicated.

• Collateral - Describe and evaluate any collateral,

indicating the marketability and/or condition thereof.

If values are estimated, note the source.

• Financial Data - Current balance sheet information

along with operating figures should be presented, if

such data are considered necessary. The examiner

must exercise judgment as to whether a statement

should be detailed in its entirety. When the statement

is relevant to the classification, it is generally more

effective to summarize weaknesses with the entire

statement presented. On the other hand, if the

statement does not significantly support or detract

from the loan, a very brief summarization of the

statement is in order.

• Summarize the Problem - The examiner's comments

should explicitly point out reasons for the

classification. Where portions of the line are accorded

different classifications or are not subject to

classification, comments should clearly set forth the

reasoning for the split treatment.

• Management's Intentions - Comments should

include any corrective program contemplated by

management.

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 page

should be completed in banks 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, the page should not include

consumer loans and overdrafts and it should be footnoted to

indicate that these assets are not included.

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Issuance of "Express Determination" Letters

to Institutions 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.

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.

An institution must request an "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.

Examination Guidelines - Institutions are responsible for

requesting "express determination" letters during each

examination that covers their loan review process, i.e.,

during safety and soundness examinations. The request can

be made verbally or in writing. For continuous examination

programs, reviewing the loan review process would include

targeted reviews of an institution’s loan review area outside

of the annual rollup examination. Examiners should not

alter the scope or frequency of examinations merely to

permit banks to use the tax-book conformity method.

When requested by an institution that has made or intends

to make the election under 12 CFR Section 1.166-2(d)(3) of

the tax regulations, the examiner-in-charge should issue an

"express determination" letter, provided the institution 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, including annual rollup

examinations under a continuous examination program, at

which the examiner-in-charge has concluded that the

issuance of the letter is appropriate.

An "express determination" letter should be issued to an

institution only if:

• The examination indicates that the institution

maintains and applies loan loss classification

standards that are consistent with the FDIC's standards

regarding the identification and charge-off of such

loans; and

• There are no material deviations from the FDIC's

standards.

Minor criticisms of the institution'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:

• The institution's loan review process relating to

charge-offs is subject to significant criticism;

• Loan charge-offs reported in the Consolidated Reports

of Condition and Income (Call Report) are

consistently overstated or understated; or

• There is a pattern of loan charge-offs not being

recognized in the appropriate year.

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 institution

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 Start Date], we reviewed the institution’s

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loan review process as it relates to loan charge-offs. Based

on our review, we concluded that the institution, 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 credit

losses

Sincerely,

[signature]

Examiner-in-Charge

[date signed]

Accounting Standards Update 2016-13, issued by the

Financial Accounting Standards Board, has replaced the

former allowance for loan and lease losses under the

incurred loss methodology with an allowance for credit

losses on loans, leases, and other financial instruments using

the current expected credit losses (CECL) methodology.

The new accounting standard applies to all banks, savings

associations, credit unions, and financial institution holding

companies that file regulatory reports for which the

reporting requirements conform to U.S. generally accepted

accounting principles (GAAP).

When an "express determination" letter is issued to an

institution, a copy of the letter as well as documentation of

the work performed by examiners in their review of the

institution'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. The issuance of an "express determination"

letter, including if concluded based on a targeted review that

occurred earlier in the continuous examination program,

should be noted in the Report of Examination according to

procedures in the Report of Examination Instructions. An

express determination letter should not be issued subsequent

to the Report of Examination being finalized and distributed

to the institution.

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 institution

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 are addressed in the Report of Examination

Instructions.

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CONCENTRATIONS

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 typically addresses

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 institution

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. Failure to monitor concentrations can

result in management being unaware how significant

economic events might impact the overall portfolio. This

will also allow management to consider areas where

concentration reductions may be necessary. Management

and the board can monitor any reduction program using

accurate concentration reports. If management is not

properly monitoring concentration levels and limits,

examiners may consider criticizing management.

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 North American Industry

Classification System (NAICS) or similar code to track

industry concentrations. Any monitoring program should

be reported regularly to the board of directors.

Refer to the Report of Examination Instructions for

guidance in identifying and listing concentrations in the

examination report.

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FEDERAL FUNDS SOLD AND

REPURCHASE AGREEMENTS

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 institution 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

institution 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 institution will

automatically conclude that the buying institution's

financial condition is above reproach without proper

investigation and analysis. If this becomes the case, the

selling institution may be taking an unacceptable risk

unknowingly.

Another area of potential risk involves selling federal funds

to an institution which may be acting as an intermediary

between the selling institution and the ultimate buying

institution. In this instance, the intermediary institution is

acting as agent with the true liability for repayment accruing

to the third institution. Therefore, it is particularly

important that the original selling institution 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 generally would

consider matters such 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 institution 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

emphasizes 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, it is prudent for the selling

institution to 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 institution 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 institution 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

institution 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 in the Report of

Examination. Also, if federal funds sold to any one buyer

equals or exceeds 100 percent of the selling institution'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 institution 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 institution is a major consideration, and the

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buying institution should satisfy itself that the selling

institution will be able to generate the necessary funds to

repurchase the securities on the prescribed date. Policy

guidelines typically 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

institution'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 institution with the selling institution continuing to

collect all interest and transmit such payments to the buying

institution.

Assessing Bank-to-Bank Credit

Because of the FDIC’s regulatory role, examiners often

possess confidential information concerning a bank

obligated on unsecured lines, Federal funds, or subordinated

notes and debentures to another bank under examination.

The files of the bank under examination may contain

insufficient information to make an informed assessment of

the credit. When this is the case, and when there is

information in the public domain to suggest that the line

involves more than a normal degree of risk, the matter

should be brought to the attention of management and the

board of the bank under examination.

However, if the bank’s credit files or public record contain

sufficient information to justify adverse classification of the

debt, then it should be classified in the report of

examination.

The following is a statement regarding such credits which

may be used in applicable situations:

The foregoing obligation of a federally insured banking

institution is listed for special mention because of publicly

available information which suggests the obligation

contains risk which is some degree greater than normal. The

following is a standard statement of the FDIC's position

regarding such credits.

"In reviewing bank-to-bank debt, the FDIC is placed in a

position of basic conflict. We may or may not be in

possession of confidential information arising from our

regulatory function with respect to the other institution. The

responsibility for properly appraising the assets of the bank

under examination in such an instance may suggest the need

to disclose adverse information, while the implied

arrangement under which we received the information

would preclude us, in good faith, from making the

disclosure. It is our policy, in view of the foregoing, not to

classify such credits adversely except where we can support

the classification without the use of information gathered

solely through privileged sources. Rather, we bring the

existence of this credit to the board's attention for whatever

review or other action it believes consistent with its sworn

responsibilities to the stockholders and depositors of the

bank under examination."

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FUNDAMENTAL LEGAL CONCEPTS AND

DEFINITIONS

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 institution under examination, is

also essential.

Uniform Commercial Code – Secured

Transactions

Article 9 of the UCC governs secured transactions; i.e.,

those transactions which create a security interest in

personal property or fixtures including goods, documents,

instruments, general intangibles, chattel paper or accounts.

Article 9 was significantly revised effective July 1, 2001,

but each individual state must adopt the changes for it to

become law. Because some states have enacted modified

versions of the UCC and subsequent revisions, each

applicable state statute should be consulted.

General Provisions

A Security Agreement is an agreement between a debtor and

a secured party that creates or provides for a security

interest. The Debtor is the person that has an interest in the

collateral other than a security interest. The term Debtor

also includes a seller of payment intangibles or promissory

notes. The obligor is the person who owes on a secured

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transaction. The Secured Party is the lender, seller or other

person in whose favor there is a security interest.

Grant of Security Interest

For a security interest to be enforceable against the debtor

or third party with respect to the collateral, the collateral

must be in the possession of the secured party pursuant to

agreement, or the debtor must sign a security agreement

which covers the description of the collateral.

Collateral

Any description of personal property or real estate is a

sufficient description of the collateral whether or not it is

specific if it reasonably identifies what is described. If the

parties seek to include property acquired after the signing of

the security agreement as collateral, additional requirements

must be met.

Unless otherwise agreed a security agreement gives the

secured party the rights to proceeds from the sale, exchange,

collection or disposition of the collateral.

In some cases, the collateral that secures an obligation under

one security agreement can be used to secure a new loan,

too. This can be done by using a cross-collateralization

clause in the security agreement.

Perfecting the Security Interest

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, or 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 authenticates and provides a

description of the collateral. A creditor's security interest

can be possessory or nonpossessory, a secured party with

possession pursuant to “agreement” means that the

“agreement” for possession has to be an agreement that the

person will have possession for purposes of security. The

general rule is an institution must take possession of deposit

accounts (proprietary), letter of credit rights, electronic

chattel, paper, stocks and bonds to perfect a security interest

therein. In a transaction involving a nonpossessory security

interest, the debtor retains possession of the collateral. A

security interest in collateral automatically attaches to the

proceeds of the collateral and is automatically perfected in

the proceeds if the credit was advanced to enable the

purchase

A party's security interest in personal property is not

protected against a debtor's other creditors unless it has been

perfected. A security interest is perfected when it has

attached and when all of the applicable steps required for

perfection, such as the filing of a financing statement or

possession of the collateral, have been taken. These

provisions are designed to give notice to others of the

secured party's interest in the collateral, and offer the

secured party the first opportunity at the collateral if the

need to foreclose should arise. If the security interest is not

perfected, the secured party loses its secured status.

Right to Possess and Dispose of Collateral

Unless otherwise agreed, when a debtor defaults on a

secured loan, a secured party has the right to take possession

of the collateral without going to court if this can be done

without breaching the peace. Alternatively, if the security

agreement so provides, the secured party may require the

debtor to assemble the collateral and make it available to the

secured party at a place to be designated by the secured

party which is reasonably convenient to both parties.

A secured party may then sell, lease or otherwise dispose of

the collateral with the proceeds applied as follows: (a)

foreclosure expenses, including reasonable attorneys' fees

and legal expenses; (b) the satisfaction of indebtedness

secured by the secured party's security interest in the

collateral; and (c) the satisfaction of indebtedness secured

by any subordinate security interest in the collateral if the

secured party receives written notification of demand before

the distribution of the proceeds is completed. If requested

by the secured party, the holder of a subordinate security

interest must furnish reasonable proof of his interest, and

unless he does so, the secured party need not comply with

his demand.

Examiners should determine institution policy concerning

the verification of lien positions prior to advancing funds.

Failure to perform this simple procedure may result in the

institution unknowingly assuming a junior lien position and,

thereby, greater potential loss exposure. Management may

check filing records personally or a lien search may be

performed by the filing authority or other responsible party.

This is especially important when the institution grants new

credit lines.

Agricultural Liens

An agricultural lien is generally defined as an interest, other

than a security interest, in farm products that meets the

following three conditions:

• The lien secures payment or performance of an

obligation for goods or services furnished in

connection with a debtor’s farming operation or rent

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on real property leased by a debtor in connection with

its farming operation.

• The lien is created by statute in favor of a person that

in the ordinary course of its business furnished goods

or services to a debtor in connection with a debtor’s

farming operation or leased property to a debtor in

connection with the debtor’s farming operation.

• The lien’s effectiveness does not depend on the

person’s possession of the personal property.

An agricultural lien is therefore non-possessory. Law

outside of UCC-9 governs creation of agricultural liens and

their attachment to collateral. An agricultural lien cannot be

created or attached under Article 9. Article 9, however,

does govern perfection. In order to perfect an agricultural

lien, a financing statement must be filed. A perfected

agricultural lien on collateral has priority over a conflicting

security interest in or agricultural lien on the same collateral

if the statute creating the agricultural lien provides for such

priority. Otherwise, the agricultural lien is subject to the

same priority rules as security interests (for example, date

of filing).

A distinction is made with respect to proceeds of collateral

for security interests and agricultural liens. For security

interests, collateral includes the proceeds under Article 9.

For agricultural liens, the collateral does not include

proceeds unless state law creating the agricultural lien gives

the secured party a lien on proceeds of the collateral subject

to the lien.

Special Filing Requirements – There is a national uniform

Filing System form. Filers, however are not required to use

them. If permitted by the filing office, parties may file and

otherwise communicate by means of records communicated

and stored in a media other than paper. 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, an

institution's rights in collateral only come into play when the

obligor 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 an obligor 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. For

consumer transactions, there are strict consumer notification

requirements prior to disposition of the collateral. For

consumer transactions, the lender must provide the debtor

with certain information regarding the surplus or deficiency

in the disposition of collateral. 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.

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 the

creditor commits no breach of the peace. 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

institution in repossessing and holding the collateral. The

third concept is retention that allows the institution 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 institution has the

right to sue the borrower for this shortfall. This is a right it

does not have under the retention concept.

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.

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

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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 that 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 that enhance the value of the

collateral as long as a perfected security interest in the

replacement or additions, or collateral is held.

Borrowing Authorization

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, an institution 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.

Bond and Stock Powers

As mentioned previously, an institution generally obtains a

security interest in stocks and bonds by possession. The

documents which allow the institution to sell the securities

if the borrower defaults are called stock powers and bond

powers. The examiner should ensure the institution 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. Refer to Federal Reserve

Board Regulations Part 221 (Reg U) for further information

on loans secured by investment securities.

Co-maker

Two or more persons who are parties to a contract or

promise to pay are known as co-makers. 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.

Loan Guarantee

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 institution

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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.

Institutions should not disburse funds on such loans until

they have the executed guarantee agreement in their

possession. Institutions 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.

Subordination Agreement

An institution extending credit to a closely held corporation

may want to have the company's officers and shareholders

subordinate to the institution'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 institution debt

to reduction of advances made by the firm's owners or

officers.

Hypothecation Agreement

This is an agreement whereby the owner of property grants

a security interest in collateral to the institution to secure the

indebtedness of a third party. Institutions often take

possession of the stock certificates, plus stock powers

endorsed in blank, in lieu of a hypothecation agreement.

Caution, however, dictates that the institution take a

hypothecation agreement setting forth the institution's rights

in the event of default.

Real Estate Mortgage

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.

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.

The examiner should determine whether the institution 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 with whom

title rests, along with any defects and encumbrances

disclosed by the abstract. Like an abstractor, an attorney is

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liable only for damages caused 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 include unauthorized corporate action, mistaken

legal interpretations, and unintentional errors in public

records by public officials. Once the institution determines

title and lien status of the property, the mortgage can be

prepared and funds advanced. The institution should record

the mortgage immediately after closing the loan. Form,

execution, and recording of mortgages vary from state to

state and therefore must conform to the requirements of

state law.

Collateral Assignment

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 institution'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 institution's assigned interest in the asset for

collateral purposes.

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CONSIDERATION OF BANKRUPTCY

LAW AS IT RELATES TO

COLLECTIBILITY OF A DEBT

Introduction

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. The

following paragraphs present 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 institution'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 institution management should

enable examiners to reach sound conclusions as to the

eventual repayment of the institution's loans.

Forms of Bankruptcy Relief

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

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.

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Functions of Bankruptcy Trustees

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.

Voluntary and Involuntary Bankruptcy

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 known 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.

Automatic Stay

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. 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; 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.

Property of the Estate

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.

Discharge and Objections to Discharge

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 to 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

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settlements are dischargeable); and submission of false or

incomplete financial statements. If an institution 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 institution. 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.

Reaffirmation

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.

Classes of Creditors

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.

Preferences

Certain actions taken by a creditor before or during

bankruptcy proceedings may be invalidated by the trustee if

they result in some 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 collectibility.

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.

• 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.

• 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.

• Preference rules also apply to a transfer of a lien to

secure past debts, if the transfer has all five elements

set forth under the first point.

• 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

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 an institution

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

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institution to setoff 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

institution within 90 days of the bankruptcy filing and for

the purpose of creating or increasing the amount to be set

off.

Transfers Not Timely Perfected or Recorded

Under most circumstances, an institution 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

promptly filed so that the possibility of losing the protection

provided by collateral is eliminated.

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SYNDICATED LENDING

Overview

Syndicated loans often represent a substantial portion of the

commercial and industrial loan portfolios of large banks. A

syndicated loan involves two or more banks contracting

with a borrower, typically a large or middle market

corporation, to provide funds at specified terms under the

same credit facility. The average commercial syndicated

credit is in excess of $100 million. Syndicated credits differ

from participation loans in that lenders participate jointly in

the origination process, as opposed to one originator selling

undivided participation interests to third parties. In a

syndicated transaction, each financial institution receives a

pro rata share of the income based on the level of

participation in the credit. Additionally, one or more

lenders take on the role of lead or agent (co-agents in the

case of more than one) of the credit and assume

responsibility of administering the loan for the other

lenders. The agent may retain varying percentages of the

credit, which is commonly referred to as the hold level.

The syndicated-lending market formed to meet basic needs

of lenders and borrowers, such as:

• Raising large amounts of money,

• Enabling geographic diversification,

• Obtaining working capital quickly and efficiently,

• Diversifying credit risk among banks, and

• Gaining attractive pricing advantages.

In times of excess liquidity in the marketplace, spreads

typically are quite narrow for investment-grade facilities,

thus making it a borrower’s market. This may be

accompanied by an easing of the structuring and covenants.

In spite of tightening margins, commercial banks are

motivated to compete regarding pricing in order to retain

other business as well as generate fee income.

Relaxing covenants and pricing may result in lenders

relying heavily on market valuations, or so-called

"enterprise values" in arriving at credit decisions. These

values are derived by applying a current-period multiple to

cash flows (which uses data from comparable companies

within the same industry), or discounting projected cash

flows over several years (which typically uses an average

cost of capital as the discount rate). This value represents

the intangible business value of a company as a going

concern, which often exceeds its underlying hard assets.

Many deals involve merger and acquisition financing.

While the primary originators of the syndicated loans are

commercial banks, most of the volume is sold and held by

other investors.

A subset of syndicated lending is leveraged lending which

refers to borrowers with an elevated level of debt and debt

service compared with cash flow. By their very nature,

these instruments are of higher risk.

Syndication Process

There are four phases in loan syndications: Pre-Launch,

Launch, Post-Launch, and Post-Closing.

The Pre-Launch Process - During this phase, the

syndicators identify the borrower’s needs and perform their

initial due diligence. Industry information is gathered and

analyzed, and background checks may be performed.

Potential pricing and structure of the transaction takes

shape. Formal credit write-ups are sent to credit officers for

review and to senior members of the syndication group for

pricing approval. Competitive bids are sent to the borrower.

The group then prepares for the launch.

An information memorandum is prepared by the agent.

This memorandum is a formal and confidential document

that should address all principal credit issues relating to the

borrower and to the project being financed. It typically

contains an overview of the transaction including a term

sheet, an overview of the borrower’s business, and quarterly

and annual certified financial statements. This document

acts as both the marketing tool and as the source of

information for the syndication.

The Launch Phase - The transaction is launched into the

market when banks are sent the information memoranda

mentioned above. Legal counsel commences to prepare the

documentation. Negotiations take place between the banks

and the borrower over pricing, collateral, covenants, and

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other terms. Often there is an institution meeting so

potential participants can discuss the company’s business

and industry both with the lead agent and with the company.

Post-Launch Phase - Typically there is a two-week period

for potential participants to evaluate the transaction and to

decide whether or not to participate in the syndication.

During this period, banks do their due diligence and credit

approval. Often this entails running projection models,

including stress tests, doing business and industry research,

and presenting the transaction for the approval process once

the decision is made to commit to the transaction.

After the commitment due date, participating banks receive

a draft credit agreement for their comments. Depending

upon the complexity of the agreement, they usually have

about a week to make comments. The final credit

agreement is then negotiated based on the comments and the

loan would then close two to five days after the credit

agreement is finalized.

Post-Closing Phase - Post-Closing, there usually is an

ongoing dialogue with the borrower about

financial/operating performance as well as quarterly credit

agreement covenant compliance checks. Annually, a full

credit analysis typically is done as well as annual meetings

of the participants for updates on financial and operating

performance. Both the agent institution and the participants

need to assess the loan protection level by analyzing the

business risk as well as the financial risk. Each industry has

particular dominant risks to be assessed.

Loan Covenants

Loan covenants are special conditions included in a loan

agreement that the borrower is required to fulfill in order for

the loan agreement to remain valid. Typically, covenants

cover several domains but can broadly be divided into

financial and non-financial categories. Effective financial

covenants establish an operating framework using

conditions defined in absolute amounts or ratios. If

exceeded by the borrower, the covenants provide lenders the

opportunity to further strengthen collateral controls or

adjust interest rates. Some examples are:

Net Worth test: restricts the total amount of debt a borrower

can incur, expressed as a percentage of net worth.

Current Ratio/ Quick Ratio test: measures liquidity.

Interest, Debt Service or Fixed Charge Coverage test:

assures that some level of cash flow is generated by a

company above its interest expense and other fixed

obligations. The proxy for cash flow is usually EBITDA

(earnings before interest, taxes, depreciation and

amortization).

Capital Expenditure Limitations: generally set according to

the company’s business plan and then measured

accordingly.

Borrowing Base Limitations: lending formula typically

based on eligible accounts receivable and inventory. At

times, the formula may also include real estate or other non-

current assets.

Leverage test: actual leverage covenant levels vary by

industry segment. Typical ratios include Total Debt divided

by EBITDA, Senior Debt divided by EBITDA and Net Debt

(subtracts cash) divided by EBITDA.

Non-financial covenants may include restrictions on other

matters such as management changes, provisions of

information, guarantees, disposal of assets, etc.

Credit Rating Agencies

The large credit rating agencies (Standard and Poor’s,

Moody’s, and Fitch Investor Services) provide coverage of

many syndicated loans at origination and periodically

during the life of the loan. Credit ratings issued by these

agencies reflect a qualitative and quantitative evaluation of

financial and other information of the prospective borrower,

including information provided by the borrower and other

non-public information.

Credit ratings may represent the overall corporate credit

rating of a borrower or reflect analysis of a borrower’s

specific financial instruments, such as their syndicated

loans. Credit ratings for each financial instrument reflect

the general credit risk of the borrower, their ability to repay

the debt, and the probability of the borrower defaulting on

the instrument in question. Some credit rating agencies also

provide separate ratings that consider the financial loss the

holder of a financial instrument such as a syndicated loan

may incur if a borrower defaults.

Overview of the Shared National Credit

(SNC) Program

The Shared National Credit (SNC) Program is an

interagency initiative administered jointly by the FDIC,

Federal Reserve Board, and the Office of the Comptroller

of the Currency. The program was established in the 1970's

for the purpose of ensuring consistency among the three

federal banking regulators in the classification of large

syndicated credits.

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Definition of a SNC

Any loan or formal loan commitment, including any asset

such as other real estate, stocks, notes, bonds and debentures

taken for debts previously contracted, extended to a

borrower by a supervised institution, or any of its

subsidiaries and affiliates, which in original amount

aggregates $100 million or more and, which is shared by

three or more unaffiliated institutions under a formal

lending agreement; or, a portion of which is sold to two or

more unaffiliated institutions, with the purchasing

institution(s) assuming its pro rata share of the credit risk.

SNCs generally include:

• Loans administered by a domestic office of a

supervised institution;

• Domestic commercial and real estate loans and all

international loans to borrowers in the private sector;

and

• Acceptances, commercial letters of credit, standby

letters of credit or similar bonds or guarantees, note

issuance facilities, revolving underwriting facilities,

Eurodollar facilities, syndications, and similar

extensions or commitments, and lease financing

receivables.

SNCs do not include:

• Credits shared solely between affiliated supervised

institutions;

• Private sector credits that are 100 percent guaranteed

by a sovereign entity;

• International credits or commitments administered in a

foreign office; or

• Direct credits to sovereign borrowers.

SNC Review and Rating Process

Teams of interagency examiners review and risk rate a

sample of credits at agent banks during the first and third

quarters of each year. Of note, SNC reviews occur regularly

at agent banks originating a significant level of SNC credits.

For agent banks with smaller SNC portfolios, credits are

only reviewed through the program on an ad hoc basis. The

SNC review sample is based on internal rating, industry,

size, and the number of regulated participants. The

regulatory rating assigned by an interagency team of

examiners is reported to all participating banks shortly after

the conclusion of the on-site review voting period. Ratings

remain active on a rolling two review basis (approximately

1 year), thus avoiding duplicate reviews of the same loan

and ensuring consistent treatment with regard to regulatory

credit ratings. Examiners should not change SNC ratings

during risk management examinations. Any material

change in a borrower’s condition should be reported to the

national SNC coordinator.

The SNC rating process includes risk rating, accrual and

TDR status. Impairment measurement and ALLL treatment

are not addressed in the SNC rating and should be reviewed

at each participant institution. Current and historical SNC

ratings can be accessed through the FDIC’s internal

systems. Designated SNC credits not reviewed in the

current SNC sample will be listed as “Not Rated.” These

credits may be reviewed separately at the participant

institution if significant to the examination scope or an

examiner believes that the credit may carry an adverse

rating.

The FDIC’s SNC office can provide examiners with

additional information to facilitate the review of “Not

Rated” credits or copies of line sheets used in the

interagency SNC review to help examiners explain rating

rationales to participant banks. In those situations where a

“Not Rated” credit is reviewed at the participant institution

and an adverse rating is assigned, examiners should

communicate their findings to the national SNC

coordinator.

SNC Rating Communication and Distribution Process

At the conclusion of each semi-annual SNC review,

electronic reports are generated, and notifications are sent

via email to participant institution contacts. They are

provided a link to retrieve a summary of ratings, applicable

loan write-ups, cover letter and a list of agent institution

contacts. These reports are available to examiners upon

request and can be retransmitted to the participant

institution contact if needed. The notification email also

marks the beginning of a 14 day window for banks to file an

appeal.

Appeals Process

Agent and participant banks may appeal any preliminary

rating. Agent and participant banks have 14 days from the

electronic distribution of preliminary results to submit an

appeal. The written appeal details the reasons why the

institution is disputing the classification and includes

documentation supporting the institution’s position. The

written appeal is sent to the applicable agency of the agent

institution for the credit in question. An interagency appeals

panel reviews the appeal, determines the final disposition of

the credit, and informs the institution of its decision in

writing. Ratings changed by the appeals process are

communicated electronically to all affected participant

banks.

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Additional Risks Associated with Syndicated

Loan Participations

An institution that purchases a participation interest in large

loan syndications faces the same risks as an institution

purchasing an ordinary loan participation from another

institution. Examiners should reference the manual section

on Loan Participations for a more in depth discussion of

related risks. As discussed in that section, an institution

purchasing a participation loan is expected to perform the

same degree of independent credit analysis on the loan as if

it were the originator. The same holds true for banks

purchasing participation interests in large syndications.

Institutions that lack the resources or skill sets to perform an

independent credit analysis on a complex loan syndication

generally refrain from participating in such a transaction.

In some cases, an institution may enter into a sub-

participation agreement in which the institution purchases a

piece of a participation from another syndicated loan

participant rather than directly from the agent institution.

As a result, the sub-participant may not be registered with

or known to the agent institution and may not receive timely

notification of risk ratings or adverse credit actions from

either the agent institution or the SNC system. Additionally,

sub-participants may not have the same legal rights or

remedies as participants of record in the syndicate, which

may give rise to other transactional and operational risk

concerns.

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CREDIT SCORING

Automated credit scoring systems allow institutions to

underwrite and price loans more quickly than was possible

in the past. This efficiency has enabled some banks to

expand their lending into national markets and originate

loan volumes once considered infeasible. Scoring also

reduces unit-underwriting costs, while yielding a more

consistent loan portfolio that is easily securitized. These

benefits have been the primary motivation for the

proliferation

of credit scoring systems among both large and

small institutions.

Credit scoring systems identify specific characteristics that

help define predictive variables for acceptable performance

(delinquency, amount owed on accounts, length of credit

history, home ownership, occupation, income, etc.) and

assign point values relative to their overall importance.

These values are then totaled to calculate a credit score,

which helps institutions to rank order risk for a given

population. Generally, an individual with a higher score

will perform better relative to an individual with a lower

credit score.

Few, if any, institutions have an automated underwriting

system where the credit score is used exclusively to make

the credit decision. Some level of human review is usually

present to provide the flexibility needed to address

individual circumstances. Institutions typically establish a

minimum cut-off score below which applicants are denied

and a second cutoff score above which applicants are

approved. However, there is usually a range, or “gray area,”

in between the two cut-off scores where credits are

manually reviewed and credit decisions are judgmentally

determined.

Most, if not all, systems also provide for overrides of

established cut-off scores. If the institution’s scoring

system effectively predicts loss rates and reflects

management’s risk parameters, excessive overrides will

negate the benefits of an automated scoring system.

Therefore, it is critical for management to monitor and

control overrides. Institutions typically develop acceptable

override limits and prepare monthly override reports that

provide comparisons over time and against the institution’s

parameters. Override reports also typically identify the

approving officer and include the reason for the override.

Although banks often use more than one type of credit

scoring methodology in their underwriting and account

management practices, many systems incorporate credit

bureau scores. Credit bureau scores are updated

periodically and validated on an ongoing basis against

performance in credit bureau files. Scores are designed to

be comparable across the major credit bureaus; however, the

ability of any score to estimate performance outcome

probabilities depends on the quality, quantity, and timely

submission of lender data to the various credit bureaus.

Often, the depth and thoroughness of data available to each

credit bureau varies, and as a consequence, the quality of

scores varies.

As a precaution, institutions that rely on credit bureau scores

often sample and compare credit bureau reports to

determine which credit bureau most effectively captures

data for the market(s) in which the institution does business.

For institutions that acquire credit from multiple regions,

use of multiple scorecards may be appropriate, depending

on apparent regional credit bureau strength. In some

instances, it may be worthwhile for institutions to pull

scores from each of the major credit bureaus and establish

rules for selecting an average value. By tracking credit

bureau scores over time and capturing performance data to

differentiate which score seems to best indicate probable

performance outcome, institutions can select the best score

for any given market. Documenting such efforts to

differentiate and select the best credit bureau score supports

a deliberative decision process.

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Although some institutions develop their own scoring

models, most are built by outside vendors and subsequently

maintained by the institution. Vendors build scoring models

based upon specific information and parameters provided

by institution management. Therefore, management must

clearly communicate with the vendor and ensure that the

scorecard developer clearly understands the institution’s

objectives. Bank management that adheres closely to

vendor manual specifications for system maintenance and

management, particularly those that provide guidance for

periodically assessing performance of the system, achieve

the most reliable results.

Scoring models generally become less predictive as time

passes. Certain characteristics about an applicant, such as

income, job stability, and age change over time, as do

overall demographics. One-by-one, these changes will

result in significant shifts in the profile of the population.

Once a fundamental change in the profile occurs, the model

is less able to identify potentially good and bad applicants.

As these changes continue, the model loses its ability to rank

order risk. Thus, for the best results, institutions must

periodically validate the system’s predictability, refine

scoring characteristics when necessary, and document these

efforts.

Institutions initially used credit scoring for consumer

lending applications such as credit card, auto, and mortgage

lending. However, credit scoring eventually gained

acceptance in the small business sector. Depending on the

manner in which it is implemented, credit scoring for small

business lending may represent a fundamental shift in

underwriting philosophy if institutions view a small

business loan as more of a high-end consumer loan and,

thus, grant credit more on the strength of the principals’

personal credit history and less on the fundamental strength

of the business. While this may be appropriate in some

cases, it is important to remember that the income from

small business remains the primary source of repayment for

most loans. Institutions that do not analyze business

financial statements or periodically review their lines of

credit may lose an opportunity for early detection of credit

problems.

The effectiveness of any scoring system directly depends on

the policies and procedures established to guide and enforce

proper use. The most effective policies include an overview

of the institution’s scoring objectives and operations; the

establishment of authorities and responsibilities over

scoring systems; the use of a chronology log to track internal

and external events that affect the scoring system; the

establishment of institution officials responsible for

reporting, monitoring, and reviewing overrides; as well as

the provision of a scoring system maintenance program to

ensure that the system continues to rank risk and to predict

default and loss under the original parameters.

Examiners should refer to the Credit Card Specialty Bank

Examination Guidelines and the Credit Card Activities

section of the Examination Modules for additional

information on credit scoring systems.

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SUBPRIME LENDING

Introduction

There is no universal definition of a subprime loan in the

industry, but subprime lending is generally characterized as

a lending program or strategy that targets borrowers who

pose a significantly higher risk of default than traditional

retail banking customers. Institutions often refer to

subprime lending by other names such as the nonprime,

nonconforming, high coupon, or alternative lending market.

Well-managed subprime lending can be a profitable

business line; however, it is a high-risk lending activity.

Successful subprime lenders carefully control the elevated

credit, operating, compliance, legal, market, and other risks

as well as the higher overhead costs associated with more

labor-intensive underwriting, servicing, and collections.

Subprime lending should only be conducted by institutions

that have a clear understanding of the business and its

inherent risks, and have determined these risks to be

acceptable and controllable given the institution’s staff,

financial condition, size, and level of capital support. In

addition, subprime lending should only be conducted within

a comprehensive lending program that employs strong risk

management practices to identify, measure, monitor, and

control the elevated risks that are inherent in this activity.

Finally, subprime lenders need to retain capital support that

is consistent with the volume and nature of the additional

risks assumed. If the risks associated with this activity are

not properly controlled, subprime lending may be

considered an unsafe and unsound banking practice.

The term, subprime, refers to the credit characteristics of the

borrower at the loan’s origination, rather than the type of

credit or collateral considerations. Subprime borrowers

typically have weakened credit histories that may include a

combination of payment delinquencies, charge-offs,

judgments, and bankruptcies. They may also display

reduced repayment capacity as measured by credit scores,

debt-to-income ratios, or other criteria. Generally,

subprime borrowers will display a range of credit risk

characteristics that may include one or more of the

following:

• Two or more 30-day delinquencies in the last 12

months, or one or more 60-day delinquencies in the

last 24 months;

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• Judgment, foreclosure, repossession, or charge-off in

the prior 24 months;

• Bankruptcy in the last 5 years;

• Relatively high default probability as evidenced by,

for example, a Fair Isaac and Co. risk score (FICO) of

660 or below (depending on the product/collateral), or

other bureau or proprietary scores with an equivalent

default probability likelihood; and

• Debt service-to-income ratio of 50 percent or greater,

or otherwise limited ability to cover family living

expenses after deducting total monthly debt-service

requirements from monthly income.

This list is illustrative rather than exhaustive and is not

meant to define specific parameters for all subprime

borrowers. Additionally, this definition may not match all

market or institution-specific subprime definitions, but

should be viewed as a starting point from which examiners

should expand their review of the institution’s lending

program.

Subprime lenders typically use the criteria above to segment

prospects into subcategories such as, for example, A, B, C,

and D. However, subprime subcategories can vary

significantly among lenders based on the credit grading

criteria. What may be an “A” grade definition at one

institution may be a “B” grade at another institution, but

generally each grade represents a different level of credit

risk.

While the industry often includes borrowers with limited or

no credit histories in the subprime category, these borrowers

can represent a substantially different risk profile than those

with a derogatory credit history and are not inherently

considered subprime. Rather, consideration should be given

to underwriting criteria and portfolio performance when

determining whether a portfolio of loans to borrowers with

limited credit histories should be treated as subprime for

examination purposes.

Subprime lending typically refers to a lending program that

targets subprime borrowers. Institutions engaging in

subprime lending generally have knowingly and

purposefully focused on subprime lending through planned

business strategies, tailored products, and explicit borrower

targeting. An institution’s underwriting guidelines and

target markets should provide a basis for determining

whether it should be considered a subprime lender. The

average credit risk profile of subprime loan programs will

exhibit the credit risk characteristics listed above, and will

likely display significantly higher delinquency and/or loss

rates than prime portfolios. High interest rates and fees are

a common and relatively easily identifiable characteristic of

subprime lending. However, high interest rates and fees by

themselves do not constitute subprime lending.

Subprime lending does not include traditional consumer

lending that has historically been the mainstay of

community banking, nor does it include making loans to

subprime borrowers as discretionary exceptions to the

institution’s prime retail lending policy. In addition,

subprime lending does not refer to: prime loans that develop

credit problems after acquisition; loans initially extended in

subprime programs that are later upgraded, as a result of

their performance, to programs targeted to prime borrowers;

or community development loans as defined in the CRA

regulations.

For supervisory purposes, a subprime lender is defined as

an insured institution or institution subsidiary that has a

subprime lending program with an aggregate credit

exposure greater than or equal to 25 percent of Tier 1 capital

plus ALLL. Aggregate exposure includes principal

outstanding and committed, accrued and unpaid interest,

and any retained residual assets relating to securitized

subprime loans.

Capitalization

The FDIC’s minimum capital requirements generally apply

to portfolios that exhibit substantially lower risk profiles

than exist in subprime loan programs. Therefore, these

requirements may not be sufficient to reflect the risks

associated with subprime portfolios. Each subprime lender

is responsible for quantifying the amount of capital needed

to offset the additional risk in subprime lending activities,

and for fully documenting the methodology and analysis

supporting the amount specified.

Examiners will evaluate the capital adequacy of subprime

lenders on a case-by-case basis, considering, among other

factors, the institution’s own documented analysis of the

capital needed to support its subprime lending activities.

Capital levels are typically risk sensitive, that is, allocated

capital should reflect the level and variability of loss

estimates within reasonably conservative parameters.

Institutions generally specify a direct link between the

estimated loss rates used to determine an appropriate ALLL,

and the unexpected loss estimates used to determine capital.

The sophistication of this analysis should be commensurate

with the size, concentration level, and relative risk of the

institution’s subprime lending activities and consider the

following elements:

• Portfolio growth rates;

• Trends in the level and volatility of expected losses;

• The level of subprime loan losses incurred over one or

more economic downturns, if such data/analyses are

available;

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• The impact of planned underwriting or marketing

changes on the credit characteristics of the portfolio,

including the relative levels of risk of default, loss in

the event of default, and the level of classified assets;

• Any deterioration in the average credit quality over

time due to adverse selection or retention;

• The amount, quality, and liquidity of collateral

securing the individual loans;

• Any asset, income, or funding source concentrations;

• The degree of concentration of subprime credits;

• The extent to which current capitalization consists of

residual assets or other potentially volatile

components;

• The degree of legal and other risks associated with the

subprime business line(s) pursued; and

• The amount of capital necessary to support the

institution’s other risks and activities.

Given the higher risk inherent in subprime lending

programs, examiners should reasonably expect, as a starting

point, that an institution would hold capital against such

portfolios in an amount that is one and one half to three

times greater than what is appropriate for non-subprime

assets of a similar type. Refinements typically depend on

the factors analyzed above, with particular emphasis on the

trends in the level and volatility of loss rates, and the

amount, quality, and liquidity of collateral securing the

loans. Institutions with significant subprime programs

generally have capital ratios that are well above the averages

for their traditional peer groups or other similarly situated

institutions that are not engaged in subprime lending.

Some subprime asset pools warrant increased supervisory

scrutiny and monitoring, but not necessarily additional

capital. For example, well-secured loans to borrowers who

are slightly below what is considered prime quality may

entail minimal additional risks compared to prime loans,

and may not require additional capital if adequate controls

are in place to address the additional risks. On the other

hand, institutions that underwrite higher-risk subprime

pools, such as unsecured loans or high loan-to-value second

mortgages, may need significantly higher levels of capital,

perhaps as high as 100% of the loans outstanding depending

on the level and volatility of risk. Because of the higher

inherent risk levels and the increased impact that subprime

portfolios may have on an institution’s overall capital,

examiners should document and reference each institution’s

subprime capital evaluation in their comments and

conclusions regarding capital adequacy.

Stress Testing

An institution’s capital adequacy analysis typically includes

stress testing as a tool for estimating unexpected losses in

its subprime lending pools. Institutions may project the

performance of their subprime loan pools under

conservative stress test scenarios, including an estimation of

the portfolio’s susceptibility to deteriorating economic,

market, and business conditions. Portfolio stress testing

scenarios may include “shock” testing of basic assumptions

such as delinquency rates, loss rates, and recovery rates on

collateral. It may also consider other potentially adverse

scenarios, such as: changing attrition or prepayment rates;

changing utilization rates for revolving products; changes in

credit score distribution; and changes in the capital markets

demand for whole loans, or asset-backed securities

supported by subprime loans.

These are representative examples. Actual factors will vary

by product, market segment, and the size and complexity of

the portfolio relative to the institution’s overall operations.

Whether stress test scenarios are performed manually, or

through automated modeling techniques, the Regulatory

Agencies will expect that:

• The process is clearly documented, rational, and easily

understood by the board and senior management;

• The inputs are reliable and relate directly to the

subject portfolios;

• Assumptions are well documented and conservative;

and

• Any models are subject to a comprehensive validation

process.

The results of the stress test exercises should be a

documented factor in the analysis and determination of

capital adequacy for the subprime portfolios.

Institutions that engage in subprime lending without

adequate procedures to estimate and document the level of

capital necessary to support their activities should be

criticized. Where capital is deemed inadequate to support

the risk in subprime lending activities, examiners should

consult with their regional office to determine the

appropriate course of action.

Risk Management

The following items are essential components of an

effective risk management program for subprime lenders.

Planning and Strategy. Prior to engaging in subprime

lending, the board and management ensure that proposed

activities are consistent with the institution's overall

business strategy and risk tolerances, and that all involved

parties have properly acknowledged and addressed critical

business risk issues. These issues include the costs

associated with attracting and retaining qualified personnel,

investments in the technology necessary to manage a more

complex portfolio, a clear solicitation and origination

strategy that allows for after-the-fact assessment of

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underwriting performance, and establishing appropriate

feedback and control systems. Appropriate risk assessment

processes extend beyond credit risk and appropriately

incorporate operating, compliance, market, liquidity, and

legal risks.

Institutions establishing an appropriate subprime lending

program proceed slowly and cautiously into this activity to

minimize the impact of unforeseen personnel, technology,

or internal control problems and to determine if favorable

initial profitability estimates are realistic and sustainable.

Strategic plan performance analysis is generally conducted

frequently in order to detect adverse trends or circumstances

and take appropriate action in a timely manner.

Management and Staff. Prior to engaging in subprime

lending, the board typically ensures that management and

staff possess sufficient expertise to appropriately manage

the risks in subprime lending and that staffing levels are

adequate for the planned volume of activity. Subprime

lending requires specialized knowledge and skills that many

financial institutions may not possess. Marketing, account

origination, and collections strategies and techniques often

differ from those employed for prime credit; thus it is

generally not sufficient to have the same staff responsible

for both subprime and prime loans. Servicing and collecting

subprime loans can be very labor intensive and requires a

greater volume of staff with smaller caseloads. Lenders

should monitor staffing levels, staff experience, and the

need for additional training as performance is assessed over

time. Compensation programs should not depend primarily

on volume or growth targets. Any targets used should be

weighted towards factors such as portfolio quality and risk-

adjusted profitability.

Lending Policies and Procedures. Lenders typically have

comprehensive written policies and procedures, specific to

each subprime lending product that set limits on the amount

of risk that will be assumed and address how the institution

will control portfolio quality and avoid excessive exposure.

Prudent institutions implement policies and procedures

before initiating the activity. Institutions may originate

subprime loans through a variety of channels, including

dealers, brokers, correspondents, and marketing firms.

Regardless of the source, it is critical that underwriting

policies and procedures incorporate the risk tolerances

established by the board and management and explicitly

define underwriting criteria and exception processes.

Subprime lending policies and procedures typically address

the items outlined in the loan reference module of the ED

Modules for subprime lending. If the institution elects to

use scoring systems for approvals or pricing, the model

should be tailored to address the behavioral and credit

characteristics of the subprime population targeted and the

products offered. It is generally not acceptable to rely on

models developed for standard risk borrowers or products.

Furthermore, the models should be reviewed frequently and

updated as necessary to ensure assumptions remain valid.

Given the higher credit risk associated with the subprime

borrower, effective subprime lenders use mitigating

underwriting guidelines and risk-based pricing to reduce the

overall risk of the loan. These guidelines include lower

loan-to-value ratio requirements and lower maximum loan

amounts relative to each risk grade within the portfolio.

Given the high-risk nature of subprime lending, the need for

thorough analysis and documentation is heightened relative

to prime lending. Compromises in analysis or

documentation can substantially increase the risk and

severity of loss. In addition, successful subprime lenders

develop criteria for limiting the risk profile of borrowers

selected, giving consideration to factors such as the

frequency, recentness, and severity of delinquencies and

derogatory items; length of time with re-established credit;

and reason for the poor credit history.

Since the past credit deficiencies of subprime borrowers

reflect a higher risk profile, appropriate subprime loan

programs are based upon the borrowers’ current reasonable

ability to repay and a prudent debt amortization schedule.

Loan repayment should not be based upon foreclosure

proceedings or collateral repossession. Institutions are to

recognize the additional default risks and determine if these

risks are acceptable and controllable without resorting to

foreclosure or repossession that could have been

predetermined by the loan structure at inception.

Profitability and Pricing. A key consideration for lenders

in the subprime market is the ability to earn risk-adjusted

yields that appropriately compensate the institution for the

increased risk and costs assumed. Successful institutions

have a comprehensive framework for pricing decisions and

profitability analysis that considers all costs associated with

each subprime product, including origination,

administrative/servicing, expected charge-offs, funding,

and capital. In addition, such pricing frameworks allow for

fluctuations in the economic cycle. Fees often comprise a

significant portion of revenue in subprime lending.

Consideration should be given to the portion of revenues

derived from fees and the extent to which the fees are a

recurring and viable source of revenue. Profitability

projections typically are incorporated into the business plan.

Also, effective management teams track actual performance

against projections regularly and have a process for

addressing variances.

Loan Review and Monitoring. Consistent with the safety

and soundness standards prescribed in Appendix A to Part

364 of the FDIC Rules and Regulations, institutions must

have comprehensive analysis and information systems that

identify, measure, monitor and control the risks associated

with subprime lending. Such analysis promotes

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understanding of the portfolio and early identification of

adverse quality/performance trends. Systems employed

must possess the level of detail necessary to properly

evaluate subprime activity. Examples of portfolio

segmentation and trend analyses are discussed in the

subprime lending loan reference module of the ED

Modules.

Comprehensive analysis considers the effects of portfolio

growth and seasoning, which can mask true performance by

distorting delinquency and loss ratios. Vintage, lagged

delinquency, and lagged loss analysis methods are

sometimes used to account for growth, seasoning, and

changes in underwriting. Analysis should also take into

account the effect of cure programs on portfolio

performance. Refer to the glossary of the Credit Card

Specialty Bank Examination Guidelines for definitions of

vintage, roll rate, and migration analysis.

Servicing and Collections. Defaults occur sooner and in

greater volume than in prime lending; thus a well-developed

servicing and collections function is essential for the

effective management of subprime lending. Strong

procedures and controls are necessary throughout the

servicing process; however, particular attention is warranted

in the areas of new loan setup and collections to ensure the

early intervention necessary to properly manage higher risk

borrowers. Prudent lenders also have well-defined written

collection policies and procedures that address default

management (e.g., cure programs and repossessions),

collateral disposition, and strategies to minimize

delinquencies and losses. This aspect of subprime lending

is very labor intensive but critical to the program's success.

Cure programs include practices such as loan restructuring,

re-aging, renewal, extension, or consumer credit

counseling. Cure programs typically are used only when the

institution has substantiated the customer’s renewed

willingness and ability to pay. Appropriate controls help

ensure cure programs do not mask poor initial credit risk

selection or defer losses. Effective subprime lenders may

use short-term loan restructure programs to assist borrowers

in bringing loans current when warranted, but will often

continue to report past due status on a contractual basis.

Cure programs that alter the contractual past due status may

mask actual portfolio performance and inhibit the ability of

management to understand and monitor the true credit

quality of the portfolio.

Repossession and resale programs are integral to the

subprime business model. Policies and procedures for

foreclosure and repossession activities typically specifically

address the types of cost/benefit analysis to be performed

before pursuing collateral, including valuation methods

employed; timing of foreclosure or repossession; and

accounting and legal requirements. Effective policies

clearly outline whether the institution will finance the sale

of the repossessed collateral, and if so, the limitations that

apply. Institutions that track the performance of such loans

are able to assess the adequacy of these policies.

Compliance and Legal Risks. Subprime lenders generally

run a greater risk of incurring legal action given the higher

fees, interest rates, and profits; targeting customers who

have little experience with credit or damaged credit records;

and aggressive collection efforts. Because the risk is

dependent, in part, upon the public perception of a lender’s

practices, the nature of these risks is inherently

unpredictable. Institutions that engage in subprime lending

must take special care to avoid violating consumer

protection laws. An adequate compliance management

program must identify, monitor and control the consumer

protection hazards associated with subprime lending. The

institution should have a process in place to handle the

potential for heightened legal action. In addition,

management should have a system in place to monitor

consumer complaints for recurring issues and ensure

appropriate action is taken to resolve legitimate disputes.

Audit. The institution’s audit scope should provide for

comprehensive independent reviews of subprime activities.

Appropriate audit procedures include, among other things,

a sample of a sufficient volume of accounts to verify the

integrity of the records, particularly with respect to

payments processing.

Third Parties. Subprime lenders may use third parties for

a number of functions from origination to collections. In

dealing with high credit-risk products, effective

management teams take steps to ensure that exposures from

third-party practices or financial instability are minimized.

This includes proper due diligence performed prior to

contracting with a third party vendor and on an ongoing

basis. Appropriate contracts provide the institution with the

ability to control and monitor third party activities (e.g.

growth restrictions, underwriting guidelines, outside audits,

etc.) and discontinue relationships that prove detrimental to

the institution.

Special care must be taken when purchasing loans from

third party originators. Some originators who sell subprime

loans charge borrowers high up-front fees, which may be

financed into the loan. These fees provide incentive for

originators to produce a high volume of loans with little

emphasis on quality, to the detriment of a potential

purchaser. These fees also increase the likelihood that the

originator will attempt to refinance the loans. Appropriate

contracts restrict the originator from the churning of

customers. Further, subprime loans, especially those

purchased from outside the institution's lending area, are at

special risk for fraud or misrepresentation. Effective

management also ensures that third party conflicts of

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interest are avoided. For example, if a loan originator

provides recourse for poorly performing loans purchased by

the institution, the originator or related interest thereof

should not also be responsible for processing and

determining the past due status of the loans.

Securitizations. Securitizing subprime loans carries

inherent risks, including interim credit, liquidity, interest

rate, and other risks, that are potentially greater than those

for securitizing prime loans. The subprime loan secondary

market can be volatile, resulting in significant liquidity risk

when originating a large volume of loans intended for

securitization and sale. Investors can quickly lose their

appetite for risk in an economic downturn or when financial

markets become volatile. As a result, institutions may be

forced to sell loan pools at deep discounts. If an institution

lacks adequate personnel, risk management procedures, or

capital support to hold subprime loans originally intended

for sale, these loans may strain an institution's liquidity,

asset quality, earnings, and capital. Consequently,

institutions actively involved in the securitization and sale

of subprime loans typically develop a contingency plan that

addresses back-up purchasers of the securities, whole loans,

or the attendant servicing functions, alternate funding

sources, and measures for raising additional capital. An

institution’s liquidity and funding structure should not be

overly dependent upon the sale of subprime loans.

Given some of the unique characteristics of subprime

lending, accounting for the securitization process requires

assumptions that can be difficult to quantify reliably, and

erroneous assumptions can lead to the significant

overstatement of an institution's assets. Prudent institutions

take a conservative approach when accounting for these

transactions and ensure compliance with existing regulatory

guidance. Refer to outstanding examination instructions for

further information regarding securitizations.

Classification

The Uniform Retail Credit Classification and Account

Management Policy (Retail Classification Policy) governs

the evaluation of consumer loans. This policy establishes

general classification thresholds based on delinquency, but

also grants examiners the discretion to classify individual

retail loans that exhibit signs of credit weakness regardless

of delinquency status. An examiner may also classify retail

portfolios, or segments thereof, where underwriting

standards are weak and present unreasonable credit risk, and

may criticize account management practices that are

deficient. Given the high-risk nature of subprime portfolios

and their greater potential for loan losses, the delinquency

thresholds for classification set forth in the Retail

Classification Policy should be considered minimums.

Well-managed subprime lenders recognize the heightened

risk-of-loss characteristics in their portfolios and, if

warranted, internally classify their delinquent accounts well

before the timeframes outlined in the interagency policy. If

examination classifications are more severe than the Retail

Classification Policy suggests, the examination report

should explain the weaknesses in the portfolio and fully

document the methodology used to determine adverse

classifications.

ALLL Analysis

An institution’s appropriately documented ALLL analysis

identifies subprime loans as a specific risk exposure

separate from the prime portfolio. In addition, the analysis

segments the subprime lending portfolios by risk exposure

such as specific product, vintage, origination channel, risk

grade, loan to value ratio, or other grouping deemed

relevant.

Adversely classified subprime loans (to include, at a

minimum, all loans past due 90 days or more) should be

reviewed for impairment, and an appropriate allowance

should be established consistent with accounting

requirements. For subprime loans that are not adversely

classified, the ALLL should be sufficient to absorb at least

all estimated credit losses on outstanding balances over the

current operating cycle, typically 12 months. To the extent

that the historical net charge-off rate is used to estimate

credit losses, it should be adjusted for changes in trends,

conditions, and other relevant factors, including business

volume, underwriting, risk selection, account management

practices, and current economic or business conditions that

may alter such experience.

Subprime Auto Lending

Underwriting. Subprime auto lenders use risk-based

pricing of loans in addition to more stringent advance rates,

discounting, and dealer reserves than those typically used

for prime auto loans to mitigate the increased credit risk. As

credit risk increases, advance rates on collateral decrease

while interest rates, dealer paper discounts, and dealer

reserves increase. In addition to lower advance rates,

collateral values are typically based on the wholesale value

of the car. Lenders will typically treat a new dealer with

greater caution, using higher discounts and/or purchasing

the dealer’s higher quality paper until a database and

working relationship is developed.

Servicing and Collections. Repossession is quick,

generally ranging between 30 to 60 days past due and

sometimes earlier. The capacity of a repossession and

resale operation operated by a prime lender could easily be

overwhelmed if the lender begins targeting subprime

borrowers, leaving the lender unable to dispose of cars

quickly. Resale methods include wholesale auction, retail

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lot sale, and/or maintaining a database of retail contacts.

While retail sale will command a greater price, subprime

lenders may consider limiting the time allocated to retail

sales before sending cars to auction in order to ensure

adequate cash flow and avoid excessive inventory build-up.

Refinancing resales are usually limited and tightly

controlled, as this practice can mask losses. Lenders

typically implement a system for tracking the location of the

collateral.

Subprime Residential Real Estate Lending

Underwriting. To mitigate the increased risk, subprime

residential real estate lenders use risk-based pricing in

addition to more conservative LTV ratio requirements and

cash-out restrictions than those typically used for prime

mortgage loans. As the credit risk of the borrower increases,

the interest rate increases and the loan-to-value ratio and

cash-out limit decreases. Prudent loan-to-value ratios are an

essential risk mitigant in subprime real estate lending and

generally range anywhere from 85 percent to 90 percent for

A- loans, to 65 percent for lower grades. High loan-to-value

(HLTV) loans are generally not considered prudent in

subprime lending. HLTV loans should be targeted at

individuals who warrant large unsecured debt, and then only

in accordance with outstanding regulatory guidance. The

appraisal process takes on increased importance given the

greater emphasis on collateral. Prepayment penalties are

sometimes used on subprime real estate loans, where

allowed by law, given that prepayment rates are generally

higher and more volatile for subprime real estate loans.

Government Sponsored entities, Fannie Mae and Freddie

Mac, have participated in the subprime mortgage market to

a limited degree through purchases of subprime loans and

guarantees of subprime securitizations.

Servicing and Collections. Collection calls begin early,

generally within the first 10 days of delinquency, within the

framework of existing laws. Lenders generally send written

correspondence of intent to foreclosure or initiate other

legal action early, often as early as 31 days delinquent. The

foreclosure process is generally initiated as soon as allowed

by law. Updated collateral valuations are typically obtained

early in the collections process to assist in determining

appropriate collection efforts. Frequent collateral

inspections are often used by lenders to monitor the

condition of the collateral.

Subprime Credit Card Lending

Underwriting. Subprime credit card lenders use risk-based

pricing as well as tightly controlled credit limits to mitigate

the increased credit risk. In addition, lenders may require

full or partial collateral coverage, typically in the form of a

deposit account at the institution, for the higher-risk

segments of the subprime market. Initial credit lines are set

at low levels, such as $300 to $1,000, and subsequent line

increases are typically smaller than for prime credit card

accounts. Increases in credit lines should be subject to

stringent underwriting criteria similar to that required at

origination.

Underwriting for subprime credit cards is typically based

upon credit scores generated by sophisticated scoring

models. These scoring models use a substantial number of

attributes, including the frequency, severity, and recency of

previous delinquencies and major, derogatory items, to

determine the probability of loss for a potential borrower.

Subprime lenders typically target particular subprime

populations through prescreening models, such as

individuals who have recently emerged from bankruptcy.

Review of the attributes in these models often reveals the

nature of the institution’s target population.

Servicing and Collections. Lenders continually monitor

customer behavior and credit quality and take proactive

measures to avert potential problems, such as decreasing or

freezing credit lines or providing consumer counseling,

before the problems become severe or in some instances

before the loans become delinquent. Lenders often use

sophisticated scoring systems to assist in monitoring credit

quality and frequently re-score customers. Collection calls

on delinquent loans begin early, generally within the first 10

days delinquent, and sometimes as early as 1-day

delinquent, within the framework of existing laws. Lenders

generally send written correspondence within the first 30

days in addition to calling. Account suspensions occur

early, generally within the first 45 days of delinquency or

immediately upon a negative event such as refusal to pay.

Accounts over 90 days past due are generally subject to

account closure and charge-off. In addition, account

closures based upon a borrower’s action, such as repeated

refusal to pay or broken promises to bring the account

current within a specified time frame, may occur at any time

in the collection process. Account closure practices are

generally more aggressive for relatively new credit card

accounts, such as those originated in the last six months.

Payday Lending

Payday lending is a subset of subprime lending. Payday

loans are usually priced at a fixed dollar fee per $100

borrowed, which represents the finance charge. Because

these loans have such short terms to maturity, usually

ranging from 14 to 45 days, the cost of borrowing, expressed

as an annual percentage rate may be high.

In return for the loan, the borrower usually provides the

lender with a debit authorization for the amount of the loan

plus the fee. Repayment is often provided through an

electronic payment of the fee and the advance with the next

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direct deposit. In addition, lenders allow payment by mail

or other means rather than electronic transfer, and may

charge a lower fee/finance charge for consumers that choose

to pay electronically. If the borrower informs the lender that

he or she does not have the funds to repay the loan, the loan

is often refinanced through payment of another fee.

General

The examination instructions described in this section apply

to banks with payday lending programs that the bank

administers directly or through a third party that partners

with the bank to offer payday loans to consumers. These

instructions do not apply to situations where a bank makes

occasional small-dollar loans as an accommodation to

borrowers that do not fall within the definition of payday

loans above nor do they apply to banks offering products

and services, such as deposit accounts and extensions of

credit, to non-bank payday lenders. These instructions

apply regardless of whether an institution is a subprime

lender, as described in the section above.

Due to the heightened safety and soundness risks posed by

payday lending, concurrent risk management and consumer

protection examinations should be conducted absent

overriding resource or scheduling problems. In all cases, a

review of each discipline's examinations and workpapers

should be part of the examination planning process.

Relevant state examinations also should be reviewed. The

subprime lending loan reference module of the ED Modules

provides procedures to assist examiners in evaluating a

payday lending program.

Examiners may conduct targeted examinations of a third

party bank partner where appropriate. Authority to conduct

examinations of third parties may be established under

several circumstances, including through the bank's written

agreement with the third party, section 7 of the Bank Service

Company Act, or through powers granted under section 10

of the Federal Deposit Insurance Act. Third party

examination activities would typically include, but not be

limited to, a review of compensation and staffing practices;

marketing and pricing policies; management information

systems; and compliance with bank policy as well as

applicable laws and regulations. Third party reviews should

also include testing of individual loans for compliance with

underwriting and loan administration guidelines, and

appropriate treatment under delinquency, and re-aging and

cure programs.

Underwriting

Institutions making payday loans may use a variety of

underwriting techniques, such as scoring systems, review of

current pay stub or proof of a regular income source and

evidence that the customer has a checking account,

consultation of nationwide databases that track bounced

checks and persons with outstanding payday loans, among

others. As described above, the Interagency Guidelines

Establishing Standards for Safety and Soundness

(Guidelines) set out the safety and soundness standards that

the agencies use to identify and address problems at insured

depository institutions before capital becomes

impaired. The Loan Documentation prong of the

Guidelines addresses assessing the ability of the borrower

to repay the indebtedness in a timely manner and ensuring

that any claim against a borrower is legally

enforceable. The Credit Underwriting prong addresses

providing for consideration, prior to credit commitment, of

the borrower's overall financial condition and resources, the

financial responsibility of any guarantor, the nature and

value of any underlying collateral, and the borrower's

character and willingness to repay as agreed. Institutions

that choose to offer payday loans with strong risk

management frameworks might adopt the following

controls, among others, to demonstrate their conformance

with these prongs of the Guidelines:

• Consideration of the consumer’s overall short-term

debt obligations relative to resources;

• Consideration of the total length of time a consumer

has had payday loan debt outstanding as an indication

of the customer’s ability to repay the payday loan

according to its term without reborrowing; and

• Consideration of any applicable laws and regulations.

Payday Lending Through Third Parties

Insured depository institutions may have payday lending

programs that they administer directly, using their own

employees, or they may enter into arrangements with third

parties. In the latter arrangements, the institution typically

enters into an agreement in which the institution funds

payday loans originated through the third party. These

arrangements also may involve the sale to the third party of

the loans or servicing rights to the loans. Institutions also

may rely on the third party to provide additional services

that the institution might otherwise provide, including

collections, advertising and soliciting applications. The

existence of third party arrangements when not properly

managed, can increase institutions’ transaction and legal

risks.

The use of third parties in no way diminishes the

responsibility of the board of directors and management to

ensure that the activity performed on behalf of the bank is

conducted in a safe and sound manner that complies with

applicable consumer protection laws. Appropriate

corrective actions, including enforcement actions, may be

pursued for deficiencies related to a third-party relationship

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that poses safety and soundness issues or compliance with

consumer protection laws.

The FDIC's principal concern relating to third parties is

whether effective risk controls are implemented. Examiners

should assess the institution's risk management program for

third-party payday lending relationships. An assessment of

third-party relationships should include an evaluation of the

bank's risk assessment and strategic planning, as well as the

bank's due diligence process for selecting a competent and

qualified third party provider. Examiners should determine

whether arrangements with third parties are guided by a

written contract and approved by the institution’s board.

Appropriate arrangements typically:

• Describe the duties and responsibilities of each party,

including the scope of the arrangement;

• Specify that the third party will comply with all

applicable laws and regulations;

• Specify which party will provide consumer

compliance related disclosures;

• Authorize the institution to monitor the third party and

periodically review and verify that the third party and

its representatives are complying with its agreement

with the institution;

• Authorize the institution and the appropriate banking

agency to have access to such records of the third

party and conduct onsite transaction testing and

operational reviews at the third party locations as

necessary or appropriate to evaluate such compliance;

• Require the third party to indemnify the institution for

potential liability resulting from action of the third

party with regard to the payday lending program; and

• Address customer complaints, including any

responsibility for third-party forwarding and

responding to such complaints.

Effective bank management sufficiently monitors the third

party with respect to its activities and performance. This

includes dedicating sufficient staff with the necessary

expertise to oversee the third party. An appropriate

oversight program also includes monitoring the third party’s

financial condition, internal controls, and the quality of its

service and support, including the resolution of consumer

complaints if handled by the third party. Oversight

programs that are documented sufficiently facilitate the

monitoring and management of the risks associated with

third-party relationships.

Concentrations

Given the potential risk of payday lending, concentrations

of credit in this line of business pose a significant safety and

soundness concern. In the context of payday lending, a

concentration would be defined as a volume of payday loans

totaling 25 percent or more of an institution’s common

equity tier 1 capital plus the ALLL or the ACL for loans and

leases, as applicable. Appropriate supervisory action may be

necessary to address concentrations, including directing the

institution to reduce its loans to an appropriate level, or

raising additional capital.

Capital Adequacy

The minimum capital requirements generally apply to

portfolios that exhibit substantially lower risk profiles and

that are subject to more stringent underwriting procedures

than exist in payday lending programs. Therefore,

minimum capital requirements may not be sufficient to

offset the risks associated with payday lending. Institutions

that underwrite payday loans may need to maintain capital

levels as high as one hundred percent of the loans

outstanding (i.e. dollar-for-dollar capital), depending on the

level and volatility of risk. Risks to consider when

determining the appropriate amount of capital include the

unsecured nature of the credit, the relative levels of risk of

default, loss in the event of default, and the level of

classified assets. The degree of legal risk associated with

payday lending should also be considered, especially as it

relates to third party agreements.

Allowance for Loan and Lease Losses

As with other loan types, institutions should maintain an

ALLL or an ACL for loans and leases as applicable, that is

appropriate to absorb estimated credit losses with the

payday portfolio. Although the contractual term of each

payday loan may be short, institutions’ methodologies for

estimating credit losses on these loans should take into

account if payday loans remain outstanding for longer

periods because of renewals and rollovers. In addition,

examiners should evaluate the institution’s assessment of

the collectibility of accrued fees and finance charges on

payday loans and whether the institution employs

appropriate methods to ensure that income is accurately

measured.

Examiners should determine that institutions engaged in

payday lending have methodologies and analyses in place

that demonstrate and document that the level of the ALLL

or the ACL for payday loans is appropriate. The application

of historical loss rates to the payday loan portfolio, adjusted

for the current environmental factors, including reasonable

and supportable forecast for institutions that have adopted

CECL, is one way to determine the ALLL or ACL needed

for these loans. Environmental factors include levels of and

trends in delinquencies and charge-offs, trends in loan

volume, effects of changes in risk selection and

underwriting standards and in account management

practices, and current economic conditions. Examiners

should be mindful that for institutions that do not have loss

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experience of their own, it may be appropriate to reference

the payday loan loss experience of other institutions with

payday loan portfolios with similar attributes. Other

methods, such as loss estimation models, are acceptable if

they estimate losses in accordance with generally accepted

accounting principles. Examiners should review

documentation to determine that institutions’ loss estimates

and allowance methodologies reflect consideration of the

principles discussed in the 2001 and 2006 Interagency

policy statements on ALLL, or if the institution has adopted

CECL, the 2020 Interagency Policy Statement on

Allowances for Credit Losses.

Classifications

The Retail Classification Policy addresses general

classification thresholds for consumer loans based on

delinquency, but also discusses examiners’ discretion to

classify individual retail loans that exhibit signs of credit

weakness regardless of delinquency status. Examiners also

may classify retail portfolios, or segments thereof, where

underwriting standards are weak and present unreasonable

credit risk, and may criticize account management practices

that are deficient.

Payday loans may have well-defined weaknesses that may

jeopardize the liquidation of the debt. Weaknesses include

limited or no analysis of repayment capacity and the

unsecured nature of the credit. In addition, payday loan

portfolios can be characterized by a marked proportion of

obligors whose paying capacity is questionable, and such

Payday loans are typically classified as Substandard.

Payday loans for which the institution has documented

adequate paying capacity of the obligors and/or sufficient

collateral protection or credit enhancement are not

classified.

Payday loans that have been outstanding for extended

periods of time evidence a high risk of loss. While such

loans may have some recovery value, it is not practical or

desirable to defer writing off these essentially worthless

assets. Short-term Payday loans that are outstanding for

greater than 60 days from origination generally meet the

definition of Loss. In certain circumstances, earlier charge-

off may be appropriate (e.g., the institution does not renew

beyond the first payday and the borrower is unable to pay,

the institution closes an account). The institution’s policies

regarding consecutive advances also should be considered

when determining Loss classifications. Where the

economic substance of consecutive advances is

substantially similar to “rollovers” – without intervening

“cooling off” or waiting periods – examiners should treat

these loans as continuous advances and classify

accordingly.

Renewals/Rewrites

The Retail Classification Policy provides guidelines for

extensions, deferrals, renewals, or rewrites of closed-end

accounts. Despite the short-term nature of payday loans,

borrowers that request an extension, deferral, renewal, or

rewrite are typically expected by institutions to exhibit a

renewed willingness and ability to repay the loan.

Institutions can refer to the Retail Classification Policy

principles that address the use of extensions, deferrals,

renewals, or rewrites of payday loans. In consideration of

the Retail Classification Policy, institutions typically:

• Limit the number and frequency of extensions,

deferrals, renewals, and rewrites;

• Prohibit additional advances to finance unpaid interest

and fees and simultaneous loans to the same customer;

and

• Ensure that comprehensive and effective risk

management, reporting, and internal controls are

established and maintained.

Accrued Fees and Finance Charges

Examiners should determine whether institutions evaluate

the collectibility of accrued fees and finance charges on

payday loans because a portion of accrued interest and fees

is generally not collectible. (For more guidance on

accounting for delinquency fees, refer to ASC Section 310-

10-25, Receivables – Overall - Recognition.) Although

regulatory reporting instructions do not require payday

loans to be placed on nonaccrual based on delinquency

status, examiners should assess whether the institution

employs appropriate methods to ensure that income is

accurately measured. Such methods may include providing

loss allowances for uncollectible fees and finance charges

or placing delinquent and impaired receivables on

nonaccrual status. After a loan is placed on nonaccrual

status, subsequent fees and finance charges imposed on the

borrower would not be recognized in income and accrued,

but unpaid fees and finance charges normally would be

reversed from income.

Recovery Practices

After a loan is charged off, institutions must properly report

any subsequent collections on the loan (refer to ASC

Section 310-10-25, Receivables – Overall - Recognition.)

Typically, some or all of such collections are reported as

recoveries to the ALLL or ACL for loans and leases. In

some instances, the total amount credited to the ALLL or

ACL for loans and leases as recoveries on an individual loan

(which may have included principal, finance charges, and

fees) may exceed the amount previously charged off against

the ALLL or ACL on that loan (which may have been

limited to principal). Such a practice understates an

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institution's net charge-off experience, which is an

important indicator of the credit quality and performance of

an institution's portfolio.

Consistent with regulatory reporting instructions, recoveries

represent collections on amounts that were previously

charged off against the ALLL or ACL for loans and leases.

Accordingly, institutions must ensure that the total amount

credited to the ALLL or ACL as recoveries on a loan is

limited to the amount previously charged off on that loan.

Any amounts collected in excess of this limit should be

recognized as income.

←

GOVERNMENT GUARANTEED LENDING

AND GOVERNMENT INSURED

MORTGAGE LENDING

Overview

Government-guaranteed lending and government-insured

mortgage lending (collectively, “GGL”) involve programs

administered by various Federal agencies

(“agency”, or

“agencies”) to support the needs of individuals, businesses,

and communities that may not qualify for conventional

loans, or to support the economic interests of the United

States (U.S.).

The agencies that administer GGL programs may extend

loans directly or provide guarantees for loans originated by

financial institutions (“institutions”) and other eligible

lenders. GGL programs typically provide funding for

commercial, agricultural, residential, disaster relief, and

educational purposes. Other agencies such as the Federal

Housing Administration (FHA) offer programs that insure

mortgage loans to protect lenders from borrower default.

Loan guarantees and mortgage insurance, which are backed

by the full faith and credit of the U.S. Government, serve as

protection against credit risk, and provide incentives for

institutions to extend loans to individuals and businesses

that may not otherwise be eligible for conventional

financing.

GGL borrowers must be creditworthy, but

generally present greater credit risk than conventional

borrowers as they may lack adequate credit history, have

weak collateral, or have lower equity.

In addition to the credit enhancement provided by the

guarantee or insurance, there are a number of reasons why

For example, Small Business Administration (SBA); U.S. Department of

Agriculture (USDA), Farm Service Agency (FSA) and Rural Development

(RD); U.S. Department of Housing and Urban Development (HUD), FHA;

Veterans Administration (VA); Export-Import Institution of the U.S.

(EXIM)

Refer to https://www.fdic.gov/resources/consumers/small-business-

topics/sba.html and https://www.fdic.gov/resources/bankers/affordable-

institutions engage in GGL activities. Some institutions

originate and hold the loans to maturity in order to provide

a long-term source of interest income (originate-to-hold),

while others sell the guaranteed portions of loans in the

secondary market to free up funds for additional lending or

investing activities, and to generate income from sales

premiums and servicing fees (originate-to-sell).

Institutions may also engage in GGL to provide borrowers

with more flexible repayment terms; manage loan

concentrations; or, reduce credit or interest rate risk.

Typically, the guaranteed or insured portion of the loan is

not included in legal lending limit calculations; however,

examiners should confirm by referencing the applicable

state lending laws. Institutions may also get credit under the

Community Reinvestment Act for GGL activities.

Risks in GGL

While a government-guarantee is an attractive loan feature,

an institution’s participation in GGL programs is not

without risk. With limited exceptions, the guarantee is

conditional, meaning the institution must comply with

certain conditions in order to fully collect upon the

guarantee.

Conditions vary by agency, but often require

that loans are prudently underwritten, approved,

documented, closed, administered, serviced, and liquidated

in accordance with the agency’s regulations and program

requirements. Noncompliance with guarantee conditions

may permit the agency to revoke the guarantee and restrict

the institution’s ability to participate in the program.

The specific agency’s regulations and program

requirements help to ensure that the mission of the agency

is being met and to the extent possible that associated risks

to the agency and the lender are limited. For example,

common requirements among the agencies are that loans are

made only to borrowers who otherwise would not be able to

secure credit on reasonable terms from another source

(commonly referred to as the “credit elsewhere”

requirement), and that funds can only be used for certain

purposes (e.g. working capital, farm production).

The agencies also typically require their lenders to maintain

an appropriate control environment, including adequate

written policies for loan origination, underwriting,

servicing, quality control, and fraud prevention. They also

expect their lenders to maintain a well-trained staff that

remains informed of agency program updates, avoids

mortgage-lending-center/products.html for links to information on Federal

Agencies and Government Sponsored Enterprises Programs & Products.

As of March 29, 2024, EXIM is the only agency whose guarantee to the

institution for certain loans (e.g. EXIM Medium-term loan program) is

unconditional and transferable.

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conflicts of interest, and complies with all applicable laws

and regulations.

When an institution engages in GGL activities without fully

understanding or complying with applicable regulations and

program conditions, its participation can introduce

increased risks to the institution, as discussed below.

• Operational risk - An institution that does not have

staff with the requisite knowledge and familiarity with

a GGL program or an adequate risk management

framework may be exposed to loss of all or a portion

of the guarantee due to staff’s inability to perform

within the agency’s regulations and program

requirements.

• Compliance risk - An institution that fails to comply

with the GGL program requirements and applicable

laws and regulations (e.g. Anti-Money Laundering

and Countering the Financing of Terrorism, Equal

Credit Opportunity Act) may be suspended by the

agency and/or lose all or a portion of the guarantee.

Depending on the law or regulation, severity of non-

compliance, or if there was consumer harm, the

institution could face civil money penalties or be

required to pay restitution.

• Credit Risk - Credit risk is mitigated in the

guaranteed portion of the loan, but only if the

institution complies with agency regulations and

program requirements. The institution assumes full

credit risk on the unguaranteed portion of the loan.

• Strategic risk - An institution whose business model

centers on GGL activities may realize reduced

profitability and liquidity impacts due to decreased

demand, increased competition, loss of delegated

authority, or suspension by the agency to participate in

the program.

• Third-Party Risk - Due to complexities involved

with GGL program requirements, institutions may

contract with third parties to provide some or all

functions related to GGL activities. Institutions that

do not have adequate oversight and controls for

managing relationships with third-parties, may realize

loss of guarantee, financial loss, and legal impacts.

• Fraud Risk - GGL programs may be susceptible to

fraud, defalcation, and other operational losses,

including by institution insiders, customers, and third

parties, especially when risk management and internal

controls are inadequate.

In addition to the above, institutions that engage in the

originate-to-sell business model are exposed to off-balance

sheet risk, and liquidity and price risks associated with

originating, funding, and managing a pipeline of loans to be

sold, as discussed below.

• Off-Balance Sheet/Servicing Risk - An institution

that originates and sells government-guaranteed loans

subject to certain representations and warranties

and/or subject to a servicing agreement, and breaches

those representations and warranties, or servicing

agreement, may need to establish a recourse liability.

• Liquidity and Price Risk - Institutions that have an

originate-to-sell model and rely on GGL loan sales for

liquidity and/or profitability may be negatively

impacted by reduced market demand, required

repurchases, adverse movements in interest rates, or

suspension by the agency for material non-compliance

with agency regulations or program requirements.

Pricing risk increases when demand for loans declines

resulting in lower premium and servicing income

(earnings impact), or longer holding periods (liquidity

impact).

• Operational Risk/Execution Risk - Institutions that

have an originate-to-sell model are subject to

disruption or unexpected developments due to loan

modifications and restructurings in the serviced

portfolio. For example, the SBA is required to

repurchase the guaranteed portion of a loan after 60

days of non-payment. The secondary market would

generally prefer the loan be repurchased than concede

interest income for an extended period of time as a

result of a restructuring involving a reduction in the

loan’s stated interest rate. The institution faces

operational and execution risk if it is not able to

facilitate the loan restructuring or loan modification,

and/or have the funds available to timely execute the

repurchase, if necessary.

• Credit/Concentration Risk - When an institution

originates large volumes of guaranteed loans to sell,

and retains only the unguaranteed portion, the

institution may develop a concentration in assets with

elevated credit risk. The institution may be exposed to

loss if these risks are not properly controlled or

mitigated. In addition, lower demand for government-

guaranteed loans in the secondary market could make

the activity no longer economical, as the benefits may

not justify the risk in the retained unguaranteed

portion.

• Compliance Risk/Strategic Risk - The originate-to-

sell model may become overly reliant on sales volume

to reach internal origination and premium income

goals. As a result, lenders may feel pressure to relax

underwriting standards or link employee performance

reviews and compensation to a targeted loan volume

without adequately considering risk. Pressure to reach

income targets and compensation practices that do not

sufficiently value prudent risk management increases

the risk of noncompliance with GGL program

requirements and the institution’s own lending

policies, as well as nonconformance with the credit

administration, underwriting, and compensation

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provisions of the Interagency Guidelines Establishing

Standards for Safety and Soundness Standards.

Furthermore, an institution that fails to comply with

the agencies’ program requirements and applicable

laws and regulations may have to repurchase loans

from investors, and/or may lose all or a portion of the

guarantee.

In summary, GGL programs provide an avenue to allow

institutions to lend to customers without exposing the

institution to excessive credit or other risk, as long as the

institution does so prudently, follows the GGL agencies’

regulations, policies and program guidelines, and complies

with all other applicable laws and regulations.

xaminers should familiarize themselves with applicable

GGL program requirements and assess whether the

institution is effectively measuring, monitoring, and

controlling the risks from engaging in GGL activities. The

scope of review of GGL activities should be risk focused

and commensurate with the institution’s participation in the

program, as well as the institution’s business model, risk

profile and complexity.

Delegated Authority Lender

Some agencies require pre-approval of certain loans,

particularly those that are larger or more complex.

Most

agencies also have delegated authority lender programs,

status lender programs, or similar programs that grant

lenders expedited processing benefits. Having this

designation generally gives the institution authorization to

make certain credit determinations and/or servicing

decisions without prior review and approval by the agency.

Agency criteria for approval varies, and may consider

factors such as loss rate and loan production volume.

aving delegated authority helps to expedite the lending

process; however, operational, compliance, credit and other

risks to the institution may increase as the agency is not

reviewing each credit decision. In addition, for institutions

that rely heavily on GGL, the loss of delegated authority

could have adverse strategic and financial impacts. Prudent

institutions that participate in delegated authority lender

programs have sufficient controls in place to ensure

compliance with the agency’s requirements, including those

related to maintaining its delegated authority lender status,

and a contingency plan should the institution unexpectedly

lose its status.

Refer to Appendix A to Part 364 of the FDIC’s Rules and Regulations

For example, EXIM loans typically require prior approval from the

agency, although the agency does have a delegated authority lender

program.

Agency Audit or Reviews

As a condition of being an approved lender, some agencies

conduct reviews or audits to assess areas such as portfolio

performance, management and operations, credit

administration, and/or compliance. Some agencies assign

risk ratings,

while others outline findings in a report or

letter at the conclusion of the examination or audit. Loan

performance reports, statistical reports, or concerns with the

institutions lending or servicing activities may also be

furnished through a web-based portal.

If deficiencies are identified, such as non-compliance with

program requirements, institutions are required to

implement corrective actions. The agencies may also

suspend, revoke or terminate an institution’s ability to

participate in the program or delegated authority to originate

government-guaranteed loans without prior agency

approval. The agencies may also issue enforcement actions

against an institution depending on the severity or frequency

of the offenses.

Agency reviews are not a substitute for an institution’s

independent audit coverage of GGL activities. Examiners

may consider agency reviews in their assessment of GGL

activities, in conjunction with independent audit reports, if

the information is timely and relevant to the activities being

reviewed. Access to agency reviews or audit reports may

be governed by agency disclosure regulations. However,

findings and discussion of any such reviews should be

reflected in the relevant board or committee minutes of the

institution. If this information is not available through the

normal examination process, and may have a bearing on the

examiners’ assessment of the GGL activities, a request for

the audit/review report from the agency should be

considered.

Guarantee Purchase/ Loss Claim Payment

Before an institution is able to collect on the guarantee, the

agency conducts a review of the institution’s compliance

with the agency’s regulations and program requirements.

This is sometimes referred to as the guarantee purchase or

loss claims review process. The process varies by agency;

however, most have guidelines on when a lender can request

payment on a guarantee, such as a minimum of 60-day

uncured delinquency. Agencies generally expect

institutions to make reasonable efforts to work with

borrowers before considering liquidation of collateral, and

require the institution or servicer to prepare a detailed

For example, the SBA has developed “PARRiS,” lender risk rating

system; Refer to https://www.federalregister.gov/

documents/2021/02/16/2021-03053/sba-lender-risk-rating-system).

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liquidation plan for the agencies’ approval as part of the

guarantee claims process.

The agency assesses an institution’s guarantee claim

package and reaches a decision with three possible

outcomes: (1) full purchase or payment of guarantee, (2)

reduced payment amount of guarantee, or “repair,” or (3)

denial of payment of guarantee. A repair is often viewed as

a fine or penalty, lowering the dollar amount of the

guarantee payment (not a change in the percentage of the

guarantee) due to a material deficiency that occurred during

origination, closing, servicing, and/or liquidation. A denial

of liability or payment is more severe than a repair as the

agency determined the institution’s action or inaction was

severe enough to negate the guarantee.

For example, in the case of an SBA loan, if an institution

fails to file a lien on equipment, the SBA may reduce the

amount of the guarantee by the value of the equipment

during the guarantee claim process. However, if the

borrower’s business fails because of a fire and the hazard

insurance coverage had expired, the SBA may deny the

entire claim. An institution is often able to provide

additional documentation to the agency to cure a deficiency

before a final determination on the guarantee claim is made.

Common reasons to deny or reduce loss claims include

incorrect loan eligibility determination, ineligible use of

proceeds, negligent loan origination or servicing (e.g. lack

of prior approval) and, failure to obtain, perfect, or maintain

the collateral or lien position.

If a loan has been sold to an investor, the agency may

require the institution to repurchase the defaulted loan, or

the agency may repurchase it directly from the investor. If

the agency repurchases the loan and finds that the institution

that originated the loan was deficient in terms of

underwriting and servicing of the loan, the agency may be

able to request indemnification from the institution for any

losses realized on the credit.

Loan Sales

Institutions with an originate-to-sell model typically sell the

guaranteed portions of loans in order to provide liquidity for

additional lending or investing, and to generate income from

sales premiums and servicing fees. In the secondary market,

government-guaranteed loans are readily marketable and

generally can be sold at a premium.

Investors buy these

loans because the interest rates are relatively high compared

to the risk, as the only risk the investor incurs is prepayment

For the purposes of loan sales, transfers of guaranteed portions of GGLs

are presumed to be at a price in excess of par (i.e., at a premium) and qualify

for sale accounting as of the transfer date.

Refer to Call Report Glossary entry for “Transfers of Financial Assets.”

risk. Loans with longer terms and higher yields realize

higher premiums.

The requirements and processes for selling government-

guaranteed loans vary by agency. For example, institutions

that originate loans guaranteed by the SBA and USDA are

able to sell the guaranteed portion of the loan in the

secondary market, but are required to retain some or all of

the unguaranteed portion of the loan and servicing rights to

ensure the institution remains responsible and committed

throughout the life of the loan.

Institutions that sell government-guaranteed loans must

comply with Financial Accounting Standards Board

(FASB) and Call Report Instructions regarding sales

treatment, income recognition, fair value measurement, and

contingent liabilities, as applicable. Under Generally

Accepted Accounting Principles (GAAP), a transfer of the

guaranteed portion of a government-guaranteed loan must

be accounted for in accordance with Accounting Standards

Codification (ASC) Topic 860 and Call Report

Instructions.

ASC Topic 860 provides that, in order for a

transfer of a portion of an entire financial asset to qualify for

sale accounting, the portion must meet the definition of a

“participating interest” and must meet all of the sales

conditions set forth in this topic. If the guaranteed portion

of the loan is transferred at a premium, the transferred

guaranteed portion and the retained unguaranteed portion of

the loan should normally meet the definition of a

“participating interest” on the transfer date.

When an institution sells a government-guaranteed loan,

and retains servicing, the institution receives a certain

percentage as a minimum servicing fee. For example, for a

$1 million loan originated with a 75 percent guarantee, a

hypothetical 10 percent premium, and a typical servicing fee

of 1 percent, the income generated from this origination

would be based on the $750,000 guaranteed portion.

Specifically, the servicing fee would be $7,500 annually

based on 1 percent of the $750,000 guaranteed portion of

the loan. It is important to note that this assumes that the

loan does not amortize and principal remains constant. In

most cases, the unpaid principal amount would decline as

the loan is repaid, so in the first year the servicing fee would

be less than $7,500. Additionally, the premium recognized

would be $75,000 based on a 10 percent premium of the

$750,000 guaranteed portion of the loan. Overall, the

institution would hypothetically recognize $82,500 in

income in the first year and $7,500 in each subsequent year

until the loan matures.

Refer to ASC topic 860 and Call Report Glossary entry for “Transfers of

Assets” for discussion of loans sold at par.

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When an institution sells a GGL and retains servicing, the

selling institution records a servicing asset representing its

right to service the portion of the loan sold. For example,

the selling institution typically receives a servicing fee of 1

percent and if the current industry practice is to receive 40

basis points for servicing compensation, the present value

of the remaining 60 basis points would be recorded as a

servicing asset at its fair value at the transfer date.

When

the benefits of servicing are expected to more than

adequately compensate the selling institution for

performing servicing, the selling institution also records an

intangible servicing asset and is required to periodically

value the servicing asset.

Risk Management Framework

A well-informed Board and management team develops a

sound understanding of GGL activities, including

applicable regulations, policies, and program requirements

prior to engaging in such activities. An appropriate risk

assessment process serves as the basis for establishing risk

controls and includes the lending program, scope of

activities, (e.g. underwriting, servicing, selling and/or

purchasing loans), and relevant risks. Proposed activities

should be consistent with a sound business strategy and the

board’s risk appetite and should be supported by an

appropriate risk management framework.

A sound risk control framework includes appropriate

policies and procedures, personnel, and systems to identify,

measure, monitor, and control the associated risks.

Appropriate internal controls include, as applicable, quality

assurance processes, loan review, credit risk rating systems,

pipeline management, concentration risk management,

portfolio servicing controls, internal and external audit, and

GGL monitoring and reporting systems. The content and

timing of reporting should be commensurate with the nature

of GGL activities, and may include GGL exposures and

performance, pipeline activity, material servicing actions,

compliance with risk limits, status tracking of any guarantee

claims or guarantee purchase activities, and agency/investor

reporting.

Policies and Procedures

Appropriate GGL policies and procedures typically address

the areas that are present in any type of lending with more

specific coverage of areas specific to the GGL program.

Depending on the nature and scope of activities, GGL

policies may specifically address the following, as

applicable.

Refer to ASC Topic 860 and Call Report Glossary entry for “Servicing

Assets and Liabilities.”

• Approved GGL lending programs and portfolio risk

limit framework;

• Credit underwriting and administration standards that,

among other things, define the agency’s unique

program requirements, including but not limited to

borrower eligibility, credit analysis criteria, credit file

documentation (including authentication of borrower

representations), and monitoring and collateral

maintenance;

• Quality controls and assurance processes which test

for and ensure compliance with GGL program rules

and regulations;

• Policy exception approval (institution and agency),

tracking, and reporting;

• Procedures for ensuring risks of GGL activities are

appropriately reflected in the ACL and capital

adequacy analyses, including stress testing, if

applicable;

• Concentration risk management practices, including

stress testing or sensitivity analysis as applicable, that

adequately measure, monitor and control related risk;

• Guidelines for secondary market activities, as

applicable,

o Guidelines for selling, and purchasing loans in the

secondary market, including effective quality

control programs;

o Pipeline management processes and controls to

limit price and liquidity risk, as well as

contingency planning to handle unplanned

liquidity or operational stresses stemming from

pipeline activities, changes in market conditions,

or agency participation restrictions;

o Servicing agreement controls, including processes

for prior approval of material servicing actions

and reporting requirements (agency or investors);

and

• Guidelines for use and oversight of third parties in

GGL activities.

Management and Personnel

Well run institutions engaging in GGL activities ensure that

management and staff possess sufficient expertise to

manage the risks in GGL and that staffing levels are

adequate for the planned volume of activity. GGL often

requires specialized knowledge and skills that financial

institutions may not possess. Marketing, origination, and

collections strategies and techniques often differ from those

employed for conventional credit. In addition, servicing

and collecting government-guaranteed loans can be labor

intensive and may require a greater number of staff.

Effective management monitors staffing levels, staff

experience and training needs, and engages in prudent

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compensation practices. Prudent incentive compensation

arrangements balance employee financial rewards with the

long-term health of the institution.

Institutions may use third-party service providers to assist

in facilitating GGL activities, depending on, and subject to

agency program requirements. For example, the SBA

requires approval of arrangements with third parties

engaged in conducting certain SBA activities.

However,

overreliance on third parties can further elevate operational

and compliance risk. Effective third-party risk management

practices help to ensure proper oversight and controls over

third parties that are engaged to assist institutions in

administering GGL activities. For example, when a third

party service provider fails to maintain an institution’s

compliance or risk controls, examiners should determine

that that an adequate process to escalate and remediate the

failure is in place.

Concentrations

If an institution holds a concentration in government-

guaranteed loans that share common risk characteristics or

have heighted sensitivity to similar economic, financial, or

other risk factors, a single economic event or adverse

market conditions could disproportionally affect asset

quality, earnings, or capital. Concentrations may be

segregated by industry (agriculture, housing), commodity

(cattle, dairy), geographic region, large borrower(s), lending

program, counterparty, or affiliated and interdependent

loans.

Examiners should consider the risk profile of the GGL

concentration when assessing concentration risk, including

whether the guarantee is conditional or unconditional; the

varying risks presented by the guaranteed and unguaranteed

portions; and, whether the risk management framework is

adequate to measure, monitor and control associated risks.

Examiners should assess whether concentration risk

management practices, including risk limits and other risk

mitigants, are adequate and commensurate with the nature

and volume of GGL exposures. For example,

concentrations with higher levels of inherent risk, such as

unguaranteed loans typically warrant robust limits and risk

mitigants. Institutions may also establish sub-limits for the

guaranteed portions of loans, both retained and sold, to

mitigate credit, liquidity and repurchase or off-balance sheet

risk should the guarantee not be honored due to

noncompliance with agency regulations and/or program

requirements. Sub-limits may also be used to control

pipeline exposures with elevated interest rate and, if

applicable, default risk.

For further discussion of compensation considerations, see Section 4.1 –

Management, Appendix A to Part 364, and the Interagency Guidance on

Sound Incentive Compensation Policies.

Proper oversight of concentrations include monitoring and

reporting of risk limits to the board, and reevaluation of risk

limits when conditions, activities or risks change. For

example, an internal audit finding that reflected concerns

with the institution’s compliance with agency

documentation standards may warrant a reevaluation of risk

limits and controls. Controls must be sufficient to allow for

effective management of concentrations. Institutions with

excessive or unmonitored exposures require heightened

scrutiny during the examination. Refer to the Report of

Examination (ROE) Instructions for guidance in identifying

and listing concentrations in the ROE.

Allowance for Credit Losses (ACL)

As with other loan types, institutions should maintain an

ACL for loans and leases that is appropriate to absorb

expected credit losses within the GGL portfolio. An

institution’s appropriately documented ACL analysis

identifies GGL loans as a specific risk exposure, giving

consideration to the differences in credit risk between the

guaranteed and unguaranteed portions of government

guaranteed loans, and the differences between conditional

and unconditional guarantees.

When reviewing the appropriateness of the institution’s

methodology, examiners consider factors such as the

performance of GGL loans, including the number of

historical issues with the guarantee claims and the loss rates

for the overall GGL segments and other factors as

appropriate. Consideration should also be given to the

quality of the institution’s underwriting and credit

administration, or third party risk management practices (if

applicable), as well as the institution’s record of compliance

with the agency’s regulations and program requirements.

Examiners should be aware that ASC Subtopic 326-20 does

not require measurement of expected credit losses on a

financial asset, or group of financial assets, for which the

expectation of nonpayment of the amortized cost basis is

zero. A loan that is fully secured by cash or cash

equivalents, such as certificates of deposit issued by the

lending institution, would likely have zero credit loss

expectations. Similarly, the guaranteed portion of

government guaranteed loans would likely have zero credit

loss expectations if these financial assets are

unconditionally guaranteed by the U.S. government. In

these instances, zero credit loss estimates would typically be

supported with historical experience, such as the

institution’s favorable claims history. If there is evidence

of noncompliance or lack of full guarantee repayment,

adjustments may be warranted.

Refer to SBA SOP 50 10 6, part 2, section A, chapter 5, paragraph D.

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Credit Risk Rating and Loan Classifications

Government-guaranteed loans are typically provided to

creditworthy borrowers that do not qualify for traditional

financing. The credit enhancement provided by the

government-guarantee or insurance is an inducement to

institutions to provide credit to borrowers that generally

present greater credit risk than conventional borrowers.

Institutions have frequently over relied on the guarantee

when risk rating loans. When assigning risk ratings,

repayment capacity should be assessed relative to the

guaranteed and unguaranteed portion of the loan.

Consideration should be given to the primary source of

repayment, such as cash flow from operations or conversion

of assets, and secondary sources of repayment, such as the

ability of the guarantors to repay, collateral support, or the

government guarantee. Consideration should also be given

to the nature (conditional or unconditional) and extent of the

protection provided by the government guarantee.

When reviewing government-guaranteed lending,

examiners should review the institution’s risk rating and

classification process. If a loan is unconditionally

guaranteed by the U.S. Government, then that portion of the

loan should generally receive a pass rating. However, if a

loan is conditionally guaranteed by the U.S. Government,

then consideration should be given to the quality of the

institution’s underwriting and credit administration, or third

party risk management practices (if applicable), as well as

the institution’s record of compliance with the agency’s

regulations and program requirements when assigning the

risk rating. For example, if there are well-defined

weaknesses or weaknesses that jeopardize the liquidation of

the debt, and there are no deficiencies identified with

underwriting, administration, servicing or other agency

program compliance, adverse classification will generally

be limited to the unguaranteed portion. However, if

deficiencies are identified, the guarantee may be at risk for

reduction or denial by the agency, and examiners should

consider adversely classifying the full loan amount.

As with assessment of any loan, the facts and circumstances

of each loan should be considered, as the presence of

deficiencies alone is not conclusive evidence that the

agency will not honor its guarantee. A review of the

institution’s purchase guarantee and loss claims process

with the agency provide insight in this regard. If a loan is

not in default, but there are credit administration

weaknesses or other negative characteristics noted,

examiners should discuss with bank management and

consider whether a Special Mention designation is

warranted.

Similar to non-government-guaranteed loans, examiners

may evaluate contingent liabilities associated with GGL

loans for credit risk and if appropriate, list contingent

liabilities for Special Mention or adverse classification.

However, this only applies to Category I contingent

liabilities (e.g. unfunded loan commitments), which are

liabilities that will give rise to a corresponding increase in

institution assets if the contingencies convert into actual

liabilities. This examination treatment does not apply to

Category II contingent liabilities, where there will be no

equivalent increase in assets if a contingency becomes a

direct liability. Refer to section 16.1 of this manual for

instructions for the report treatment of Category II

contingent liabilities.