Risk Management Manual of Examination Policies - FDIC

LOANS Section 3.2
received from the new loan, discounted at the current
market rate for this type of credit, and the present value of
the principal to be received, also discounted at the current
market rate. This economic value is the proper carrying
value for the asset at its origination date, and if less than
the fair value less cost to sell at time of foreclosure (e.g.,
$78,000 vs. $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 resale of the property. However, the loss
should be treated as "other operating expenses" 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. Interest income is earned on the
restructured loan at the previously established market rate.
This is computed by multiplying the carrying value (i.e.,
face amount of the loan reduced by any principal
payments, less unearned discount) by that rate (20 percent).
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 bank 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 bank 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 - When 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 FAS 114 unless the loans are measured at fair
value or the lower of cost or fair value. If the fair value of
the restructured loan is less than the book value of that
loan, FAS 114 requires impairment to be recognized as a
valuation allowance against the loan. For regulatory
reporting and examination report purposes, this valuation
allowance should be included as part of ALLL. If the
excess amount of the loan’s book value is determined to be
uncollectible, this excess amount should be promptly
charged-off against the ALLL.
For example, in lieu of foreclosure, a bank 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 bank 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 bank does not believe the loan is collateral dependent.
In this situation, the bank would record the restructured
loan at the present value of the new note amount
($110,000) discounted at the 10 percent rate specified in
the original contract. This amount becomes the loan’s fair
value. The difference between the calculated fair value
and the book value of the bank’s restructured loan (which
includes accrued interest, net deferred loan fees or costs,
and unamortized premium or discount) is recognized by
creating a valuation allowance with a corresponding charge
to the provision for loan and lease losses. As a result, the
net book value of the restructured loan is reflected at fair
value.
Combination Approach - In some instances, the bank
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
should be reduced by the fair value of the assets received
and the remaining investment accounted for as a
restructuring involving only modification of terms.
Examination Report Treatment - Examiners should
continue to classify troubled loans, including any troubled
collateral dependent loans, based on the definitions of
Loss, Doubtful, and Substandard. When a loan is
collateral dependent, any portion of the loan balance which
exceeds the fair value of the collateral should be promptly
charged-off against the ALLL. For other loans that are
impaired or have been restructured, the excess of the book
value of the loan over its fair value (or fair value less cost
to sell, as appropriate) is recognized by creating a
valuation allowance which is included in 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 collateral dependent loans, or portions
thereof, are uncollectible, these amounts should be
promptly charged-off against the ALLL, regardless of
whether an allowance was established to recognize
impairment under FAS 114.
An examiner should not automatically require an additional
allowance for credit losses of impaired loans over and
above what is calculated in accordance with these
standards. However, an additional allowance on impaired
loans may be necessary 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
Loans (12-04) 3.2-48 DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation