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- Hi, I'm Adam Drais, a Senior Risk Management Examiner
in the Salt Lake City Field Office.
- And I'm Jaclyn Valderrama, a Case Manager
in the San Francisco Regional Office.
In this segment, we're going to discuss the three methods
of measuring impairment under Accounting Standards
Codification, or ASC 310, formerly known as FAS 114.
We're also going to address the assumptions to be made
when performing impairment measurements, and, finally,
we're going to review some examples of measuring
impairment.
Let's begin by discussing the three methods of measuring
impairment under ASC 310.
ASC 310 states, "When a loan is impaired, a creditor shall
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 or the fair value of collateral,
if the loan is collateral dependent."
In other words, there are three ways to measure
impairment under ASC 310:
1) The present value of expected future cash flows,
2) The fair value of the collateral,
if the loan is collateral dependent, or
3) The loan's observable market price, which would
seldom exist for a community bank's impaired loans.
Let's discuss using the present value of expected
future cash flows method, or the cash flows method.
Unless an impaired loan is collateral dependent,
the appropriate method for measuring the amount
of impairment is virtually always the cash flows method.
ADAM DRAIS: When using the cash flows method
to measure impairment,
the governing principle is that management must determine
its best estimate of these cash flows.
Management's estimate of the amount and timing of expected
future cash flows should be based on reasonable
and supportable assumptions and projections.
Those cash flows are then discounted by the effective
interest rate - keeping in mind that if the rate was
modified as part of a Troubled Debt Restructuring or TDR,
the discount rate is the original effective
interest rate.
When estimating future cash flows, balloon payments
or the sale of collateral may be future cash flow events.
So, management must have a reasonable and supportable
basis for projecting when these events will occur
and then discount the resulting future cash flows.
- For example, if an impaired loan is dependent on the cash
flow of a struggling business, it would be inappropriate
to assume full repayment of a large balloon payment
at maturity since it would probably be difficult
for the borrower to secure financing from another lender
to make that balloon payment.
Likewise, if management projects that the collateral
must be sold at a future date, the projection must consider
such factors as the selling costs and the time required
for a holding period.
In short, management must be realistic in both the amount
and timing of future cash flow projections.
- We occasionally see cash flow projections where management
assumes that the bank will receive all contractually
required payments as scheduled.
Jackie, what advice can you share about these types
of projections?
- Well, it is generally inappropriate for management
to assume a "perfect pay" scenario when using this
method since it is unlikely that "perfect pay" is the best
estimate of expected future cash flows.
If management assumes perfect future payment performance,
then the resulting impairment would be very small or zero.
It would be considered inappropriate to identify
a loan as impaired, and then assume that all payments
will be made according to contractual terms.
This is because, when an individually evaluated loan
is deemed to be impaired, it means that, based on current
information and events, it is probable that the bank
will be unable to collect all amounts due according
to the contractual terms of the loan agreement.
In other words, when making its best estimate of expected
future cash flows, management should consider default
and prepayment assumptions as well as existing environmental
factors, relevant to the collectability of the loan.
We've provided examples of this type of adjustment
in the tabletop exercises that can be accessed via a link
on the Technical Assistance Video Program webpage
at FDIC.gov.
ADAM DRAIS: One last important item
to mention regarding the cash flows method
is that the measured impairment remains
in the Allowance for Loan and Lease Losses.
Now that we've covered measuring impairment under
the cash flows method, we'd like to cover the fair value
of the collateral method.
As we discuss this method, please keep in mind
that regulatory guidance is more prescriptive than GAAP
and requires the use of this method in measuring impairment
for all collateral dependent loans.
- Could you clarify what the term "collateral dependent"
means?
- Sure.
The Call Report Instructions define collateral dependent
as follows: "a loan is collateral dependent
if repayment of the loan is expected to be provided solely
by the underlying collateral and there are no other available
and reliable sources of repayment."
In other words, the borrower and any guarantors do not have
the capacity to make more than nominal payments on the loan,
and the only source for repayment is from selling
or operating the collateral.
Conversely, if the borrower or any guarantor has outside
resources that can provide for more than nominal payments,
then the loan is not collateral dependent; however,
these other repayment sources must be available and reliable.
- Would you automatically consider an impaired loan
collateralized by an income-producing commercial
office building "collateral dependent" since repayment
comes from lease income?
- While the primary repayment source is lease income
from the collateral, we cannot automatically conclude
that the loan is collateral dependent.
We must determine if the borrower and any guarantors
have payment capacity outside of the income generated
by the property.
To be collateral dependent, the collateral is the "sole"
source of repayment.
So, we would not automatically consider an impaired loan
collateralized by an income-producing commercial
office building to be "collateral dependent."
- Now that we've defined the term "collateral dependent,"
let's discuss measuring impairment using the fair
value of collateral method, which, again, is required
by regulators for all collateral dependent loans.
As we just mentioned, when dealing with a collateral
dependent loan, there are two methods of repayment -
sell the collateral or operate the collateral.
The method of repayment determines how we measure
the amount of impairment.
The first situation deals with selling the collateral.
If a bank plans to obtain possession and liquidate
the collateral, in other words sell the collateral, the first
step would be to establish the "as is" fair value
of the collateral.
Next, the bank would be required to estimate the cost
to sell the collateral.
Finally, the bank would almost always be required to charge off
any amount of the loan that exceeds the fair value
less selling costs.
- The second situation deals with operating
income-producing real estate collateral.
In some situations, management might feel that the best way
to improve the collectability of a collateral dependent
impaired loan is to work with the borrower and try
to improve the profitability of the property while still
operating the collateral.
In these circumstances, the amount of impairment
and what happens with that impairment can change depending
on the situation.
JACLYN VALDERRAMA: This graphic illustrates
how to measure the impairment and determine
the amount of charge-off, if any.
Note that the initial impairment amount in each
scenario is the same - it is the difference between
the loan balance and the "as is" fair value of the collateral.
However, the amount of charge-off differs
in the three scenarios and is based on management's answers
to two questions regarding the terms of the debt
and the condition of the property.
First, do the terms of the debt provide assurance
of repayment of both principal and interest?
If the terms include interest-only payments, long
amortization schedules, or any terms that are concessionary,
then it's difficult to say "yes" to the assurance test.
Second, is the property in question stabilizing?
Management must be able to demonstrate, based upon
detailed market analysis, that the property is expected
to stabilize in a reasonable period of time.
ADAM DRAIS: As you can see, if the loan
terms provide reasonable assurance of repayment
and the property is stabilizing,
then the amount that is charged off is zero.
The measured impairment is the difference between the loan
balance and the current "as is" fair value
of the collateral, and is provided for in the ALLL.
It is probably worth noting however, that while this
situation is possible, it is often not the case
with impaired credits.
JACLYN VALDERRAMA: The situations covered
in the next two columns are more common.
In the middle column, the loan terms do not provide
reasonable assurance of repayment; however, management
can reasonably estimate that the property is expected
to stabilize.
In this case, management must charge-off any principal
balance above the stabilized value of the property because
there is doubt about the collectability of that amount.
As noted earlier, the initial impairment provided for within
the ALLL is the entire difference between the loan
balance and the "as is" fair value of the collateral.
The difference between the loan balance
and the stabilized value is then charged off.
The difference between the stabilized value
and the "as is" fair value remains in the ALLL
as the amount of loan impairment after charge-off.
Finally, in the worst case scenario, the terms do not
provide assurance of repayment, and management
cannot support an expectation that the property
will stabilize.
In this case, management must charge off the entire amount
of the loan's allowance; in other words, write the loan
down to the "as is" fair value of the collateral.
This scenario is very similar to the process when management
plans to sell the collateral, except selling costs are not
deducted.
ADAM DRAIS: In our experience, this last
column is often a precursor to liquidating the collateral.
However, banks should periodically compare
the present value of the workout to foreclosure.
If the present value of the workout is greater than
liquidation, then the bank may want to work with the borrower
to mitigate loss.
- Now that we've covered measuring impairment using
the fair value of collateral method, we'd like to discuss
the last method for measuring impairment - using
the observable market price of the loan.
This method is very uncommon.
An observable market price implies a ready market where
assets are regularly traded such as an equity or debt
security.
Nonperforming commercial loans rarely have observable market
prices, so this method would generally not be a practical
substitute for the cash flows method.
If using this method, the bank must document the amount,
source, and date of the observable market price,
and provide for the measured impairment in the ALLL.
- We've just covered the three methods for measuring
impairment.
Before we walk through some examples, we'd like to address
nominal impairment measurements.
We occasionally encounter situations where a bank's
impaired loans have a measured impairment of zero.
This is generally inappropriate.
Unless management has charged off part of the loan,
the impairment amount should usually not equal zero.
Generally, the amount allocated for a loan
in the Allowance should not decrease when a loan is measured
for impairment under ASC 310 when compared to the allocation
under ASC 450.
If the impairment calculation results in zero impairment,
management should revisit whether the loan is truly
impaired.
Remember, the definition of an impaired loan states
that it is probable that the creditor will not collect
all amounts due according to the contractual terms
of the loan agreement.
If this is true, it would be difficult to support a zero
impairment measurement.
If the loan is indeed impaired, management should
revisit the assumptions used in the cash flow projections
and ensure that they are applying the proper discount
rate.
If using the collateral dependent method
and the impairment calculation results in zero impairment,
management should revisit the fair value of the collateral.
At times, we see impaired collateral dependent loans
with very low or even zero impairment amounts, which
are typically based on stale or unsupported appraisals.
Management should be wary of these situations, as they may
indicate the need to reassess the fair value of the
collateral.
- I agree.
In fact, both the 2001 and 2006 policy statements require
management to consider the following items when
evaluating fair value.
1) The volatility of fair values,
2) The timing and reliability of the appraised value,
3) The timing of the inspection of the collateral,
4) Confidence in the bank's lien position,
5) Historical losses on similar loans, and
6) Other factors as appropriate for the loan type.
In summary, it is unusual to have very low or zero
impairment for impaired loans.
Unless there has been a partial charge-off, it does
not make sense to identify a loan as impaired, meaning that
you are not going to collect all interest and principal
according to contractual terms, and then to identify
the loss potential as zero.
- As we conclude this discussion on measuring impairment under
ASC 310, and before we share examples, we should emphasize
that management must revisit the impairment calculation
every quarter.
Management should update their assumptions and calculations
to reflect the current conditions of the loan
and adjust the Allowance as necessary.
Alright, let's walk through a couple of examples relating
to impairment.
In our first example, this loan was originally
for an owner-occupied real estate transaction.
However, the borrower's business failed,
and the borrower now leases the property to a third party.
The bank obtained an assignment of rents; however,
the bank forecasts that rental income may be insufficient
to service the loan.
The borrower has no other significant assets or other
cash flow sources.
Management does not plan to foreclose or sell
the collateral.
Now, our first question.
What is the appropriate method for measuring impairment?
Jackie, what do you think?
- Well, since our only source of repayment is the collateral,
I would say this is a collateral dependent loan.
So, we must measure this loan for impairment
using the fair value of the collateral method.
ADAM DRAIS: Exactly. Now...
Are selling costs deducted
from the fair value of the collateral?
JACLYN VALDERRAMA: No.
Selling costs are not deducted because bank management
does not plan to foreclose or sell the collateral.
They plan to allow the borrower to operate and try to stabilize
the income-producing real estate collateral.
ADAM DRAIS: Excellent.
Now, one last question...
Does the impairment amount remain in the ALLL,
is there a confirmed loss to charge off,
or is it a combination of both?
JACLYN VALDERRAMA: Well, recall from our discussion
a few minutes ago that the answer depends on two issues.
First, is there assurance of repayment,
and second, is the property stabilizing?
ADAM DRAIS: Exactly!
And in this example, we did not provide enough information
to answer those two questions.
JACLYN VALDERRAMA: Let's walk through another example.
This time, we have a working capital line of credit
to an auto body shop.
The collateral consists of Accounts Receivable,
Inventory, Fixed Assets, and a second deed of trust
on the borrower's residence.
The business generates adequate cash flow to service the loan;
however, management identified this loan as impaired
because of delinquency.
Well, Adam, what is the appropriate method
for measuring impairment?
ADAM DRAIS: Since the business is generating
cash flow, the loan is not collateral dependent.
So, the appropriate method for measuring impairment
is the present value of expected future cash flows.
JACLYN VALDERRAMA: Exactly!
Next, what assumptions should be considered
when estimating cash flow?
ADAM DRAIS: Well, management must provide
its best estimate, which includes the amount
and timing of future cash flows, and any balloon payments
or other terminating cash flow events.
Also, management needs to adjust their estimates
for default assumptions - in other words,
the typical default rate on these types of loans,
adjusted for current conditions and credit factors.
JACLYN VALDERRAMA: I completely agree.
And finally, does the impairment amount remain in the ALLL,
is there a confirmed loss to charge off,
or is it a combination of both?
ADAM DRAIS: In this case,
the impairment amount remains in the ALLL
since there is not a confirmed loss.
JACLYN VALDERRAMA: Correct.
If you found these examples helpful, we have provided
additional ones in the tabletop exercises that can be found
on the FDIC's Technical Assistance Video Program webpage
at FDIC.gov.
ADAM DRAIS: In this segment,
we discussed the various methods
for measuring impairment according to ASC 310.
These methods include:
1) The present value of expected future cash flows method,
2) The fair value of collateral method, and
3) The observable market price method.
We emphasized management should use the cash flows method
for measuring impairment,
unless the credit is collateral dependent.
We also noted that the observable market price method
is rarely used.
When using the cash flows method, we emphasized
that cash flow projections, including any balloon payments
or other terminating cash flows, must be reasonable
and well-supported, and should take
into consideration default assumptions.
Projections should be discounted at the effective interest rate
to derive the present value.
We also emphasized that the fair value of collateral
method should only be used for collateral dependent loans
and is required by regulators
for all collateral dependent loans.
Collateral dependent loans are defined as loans
that are solely dependent on the sale or operation
of the collateral for repayment.
Finally, we discussed the differences
in measuring impairment between these two types of
collateral dependent loans.
We hope this segment has been helpful in understanding
the methods for measuring impairment under ASC 310.