Risk Management Manual of Examination Policies - FDIC

LOANS Section 3.2
take steps to ensure that exposures from third-party
practices or financial instability are minimized. Proper due
diligence should be performed prior to contracting with a
third party vendor and on an ongoing basis thereafter.
Contracts negotiated should 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.
Contracts should 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. Management
must also ensure that third party conflicts of 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 reputation risk, 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 should
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. Institutions should
take a conservative approach when accounting for these
transactions and ensure compliance with existing
regulatory guidance. Refer to outstanding memoranda and
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 should 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
The institution’s documented ALLL analysis should
identify subprime loans as a specific risk exposure separate
from the prime portfolio. In addition, the analysis should
segment 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.
Pools of adversely classified subprime loans (to include, at
a minimum, all loans past due 90 days or more) should be
reviewed for impairment, and an adequate allowance
should be established consistent with existing interagency
policy. 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
expected credit losses, it should be adjusted for changes in
Loans (12-04) 3.2-70 DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation