Identifying FAS 114 Loans (ASC 310-10-35) for impairment analysis and calculating the appropriate reserve amount is a vital part in an institution’s allowance calculation. While there are consultants or software solutions that can help in this calculation, an important part of this procedure is using the appropriate valuation method to calculate the given reserve for each impaired loan. As guidance illustrates, there are three valuation methods for FAS 114 impairments. They include the fair market value of collateral, the present value of future cash flows, and loan pricing.
An impaired collateral-dependent loan must be assessed for impairment based on the fair market value of collateral to meet specific regulatory reporting requirements. As many institutions must accommodate collateral-dependent loans that have not been restructured or loans for which the borrower cannot make future cash payments, the fair market value of collateral is widely used in reserve calculations.
When to Use Collateral
Determining when to use collateral valuation instead of cash flows can actually be one of the most difficult steps in the impairment. But it is also a critical decision that examiners will question because the three acceptable methods for evaluating a FAS 114 impaired loan could each require a different level of reserve, impacting the bank’s earnings and loss provisions.
For the two most commonly used methods (fair market value of collateral and present value of future cash flows), the appropriate impairment method is dictated by the answer to one question: Is the loan collateral dependent? If so, use the fair market value of collateral. Otherwise the present value of future cash flows is more appropriate.
The fair value of collateral should be utilized when repayment is entirely based on the sale or operation of the collateral, assuming all other cash flow sources are expected to be “no more than nominal.” And this often requires judgment on the part of the analyst, concerning the availability or dependability of other repayment sources.
For this impairment, the expected revenue from the sale or operation of collateral, less selling costs, yields the value to hold against the total recorded investment of the subject loan. Normally this occurs because the borrower does not have the ability to make sufficient cash flow payments.
In other scenarios where the loan is not collateral dependent, the present value of future cash flows should be utilized.
There are other specific items to consider when identifying if a loan is collateral dependent:
Would cash flow payments be no more than nominal amounts? If so, fair market value of collateral should be used.
Will additional guarantors tied to the loan relationship and loan agreement provide cash flow support? If so, present value of future cash flows should be used.
If cash flow is generated by business operations or outside of the collateral securing the subject loan, the loan should not be considered collateral dependent, and present value of future cash flows should be used if those amounts are more than nominal payments. For example, if an impaired loan is collateralized by a hotel, then cash flow would be expected from rental income generated by the operation of the hotel, rendering it collateral dependent. If the loan is collateralized by an owner-occupied building for a retail store, then cash flow would be generated by the business’s operations rather than the collateral’s operations.
If only a portion of the cash flow is generated by the sale or business operation of the collateral, the loan would not be collateral dependent, and present value of future cash flows should be used.
Appraisal values should be updated as frequently as possible since they drive the fair market value of collateral. Guidance states that collateral should be updated at least on a yearly basis to account for the most current appraisal information within the FAS 114 assessment.
Appraisal source, appraisal date, original value, appraisal value, appraisal discount rates and any selling costs associated with the collateral for the FAS 114 impairment analysis should be included in the institution’s allowance calculation. This vital information should be securely stored yet easily accessed by the appropriate party to utilize or document a specific reserve.
Making the initial lending decisions based on accurate collateral data and having processes in place to capture updated data allow an institution to manage risk and capital positions before a loan is even on the books. This process can be shored up by:
Presenting collateral when doing loan analysis. Loan- to-value percentages should be documented and presented specific to each loan and globally.
Matching loan-to-value percentages and values with the given documentation on the collateral. Appraisals and descriptions should directly impact loan information as it relates to the LTV calculation.
Knowing your collateral. Go out and collect the most current information you can and tighten processes to ensure appraisal collection is part of a robust loan administration system.
Documenting LTV requirements in the loan analysis. This could vary based on collateral types — accounts receivable, inventory, equipment, etc. — but a bank or credit union should not lend when the LTV percentage requirements fall below underwriting guidelines.
Remarkably, even though this information is so important to the impairment analysis most institutions admit that maintaining updated appraisal information continues to be one of the most difficult items to manage at their institution.
Why It Is Important
Leslie Schlanger, assistant vice president of Community Bank of Bergen County in New Jersey, who specializes in the bank’s ALLL calculation, said, “An institution should always consider this information to be as updated as possible when applying the collateral to the total recorded investment for the reserve calculation. Not having the most updated collateral valuation would be detrimental to the institution’s accuracy of the reserve and would certainly raise red flags with examiners.”
Managing your collateral at the beginning and through the end of a loan cycle allows an institution to manage risk and provide more accurate calculations that drive the bottom line. Having an updated appraisal on collateral will lead to a more accurate and defensible reserve calculation every time.
Garrett Morris is senior risk management consultant at Sageworks. His email address is firstname.lastname@example.org.
Copyright 2014 BankNews Media (March 2014)