Regulators and financial institutions have been trying for some time now to come to an understanding of what type of how workout strategies affect the classification of loans and the corresponding impact on estimates of loan losses. On October 30 the federal banking regulators published guidance on prudent commercial real estate loan workouts that addresses these issues. The guidance addresses some of the most contentious areas of disagreement between banks and examiners. One of those areas is the impact of a decline in value of collateral in situations where the borrower or guarantors have the ability to service the loan. The new guidance tells examiners that renewed or restructured loans to borrowers who have the ability to repay their debts according to reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance. This is a significant change from the manner in which examiners have been classifying acquisition and development loans in the past and time will tell exactly how the examiners will in fact deal with such loans in the future.
A problem loan workout can take many forms, including a renewal or extension of loan terms, extension of additional credit, or a restructuring with or without concessions. The key to any loan workout is that the renewal or restructuring should improve the lender’s prospects for repayment of principal and interest and be consistent with sound banking, supervisory, and accounting practices.
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On June 23, 2009, the FDIC issued Financial Institutions Letter FIL-33-2009, which contains final amendments to Part 363 of the FDIC’s regulations regarding annual independent audit and reporting requirements for insured institutions with $500 million or more in total assets. The amendments are intended to clarify what must be included in a Part 363 Annual Report. The reporting obligations differ between institutions with total assets, as of the beginning of the fiscal year, between $500 million and less than $1 billion, and of $1 billion or more. Unless otherwise noted the amendments became effective on August 6, 2009. We summarize the main elements of Part 363, as amended, below.
Audit Report Requirements
Part 363 requires the following to be included in the Part 363 Annual Report:
For institutions with total assets between $500 million and less than $1 billion
- Audited comparative financial statements;
- The independent public accountant’s report on the audited financials; and
- A management report containing (i) a statement of management’s responsibilities for preparing annual financial statements, establishing and maintaining adequate internal controls, and complying with safety and soundness laws and regulations pertaining to insider loans and dividend restrictions, and (ii) a management assessment of the institution’s ability to comply with laws and regulations relating to insider loans and dividend restrictions, stating management’s conclusion on compliance with the laws and regulations.
For institutions with total assets of $1 billion or more
In addition to the items required for institutions with total assets between $500 million and less than $1 billion, institutions with total assets of $1 billion or more must provide the following:
- The management report must also contain an assessment by management on the effectiveness of the institution’s internal controls over financial reporting that identifies the internal control framework, states that the assessment included controls to ensure financial statements were prepared in accordance with regulatory instructions, states management’s conclusion whether this internal control is effective, and discloses any material weaknesses in these internal controls; and
- The independent public accountant’s attestation report concerning the effectiveness of the institution’s internal controls over financial reporting.
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On August 28, 2009, the FDIC published Financial Institution Letter (FIL) 50-2009 announcing that the de novo period for state nonmember institutions is increasing from three years to seven years. The new policy is in response to depository institutions insured fewer than seven years being overrepresented on the list of failed institutions in 2008 and 2009.
Bottom line
Pay attention to your business plans! First, banks less than seven years old must keep a close eye on how their performance matches up with the projections in the bank’s approved business plan. Second, such banks need to seek prior regulatory approval for an amended business plan if the bank expects to materially deviate from that plan. Third, such banks should be particularly mindful to avoid loan concentrations and to avoid using brokered deposits or other wholesale funding at levels not contemplated in their approved business plan.
Applicability
The new policy applies to existing newly insured institutions (banks less than seven years old). There is a general exception for de novo institutions that are subsidiaries of “eligible holding companies.” Eligible holding companies are those with consolidated assets of at least $150 million, BOPEC ratings of at least 2 for bank holding companies and an above average or “A” rating for thrift holding companies, and at least 75% of their consolidated depository institution assets comprised of “eligible depository institutions.” An “eligible depository institution” is one that received a 1 or 2 composite rating and compliance rating at its most recent exams, has a satisfactory or better CRA rating, is well-capitalized, and is not subject to any type of regulatory enforcement action. Even for subsidiaries of “eligible holding companies,” the FDIC has retained discretion to extend the new policy to this set of eligible holding companies.
Heightened capital requirements
Newly insured banks are required to maintain a Tier 1 leverage ratio of 8% during the de novo period. Under the new policy, all banks less than seven years old will be required to maintain this heightened ratio.
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On April 24, 2009, the Federal Reserve published a white paper describing the process and methodologies employed by the federal banking supervisory agencies in their forward-looking capital assessment of large U.S. bank holding companies. The white paper is thin on new details, but does provide a base for understanding the stress tests being undertaken of 19 bank holding companies with total assets in excess of $100 billion.
Purpose and Effect of the Stress Tests
The stress tests are designed as the first part of the Capital Assistance Program to demonstrate which institutions the government believes will need to raise additional capital. If a stress test demonstrates that an institution requires additional capital, the institution will be required to enter an agreement to issue convertible preferred securities to the U.S. Treasury in an amount sufficient to meet the capital shortfall under the TARP Capital Assistance Program. Each such institution will then be permitted up to six months to raise private capital in public markets to meet their capital needs, and would be able to cancel the obligation to the government without penalty. Participants would also be given the opportunity to convert their existing TARP Capital Purchase Program preferred stock into the convertible preferred stock to be issued under the TARP Capital Assistance Program (such a conversion would not affect the institution’s Tier 1 capital, but could affect the institution’s tangible common equity and their dividend obligations).
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The FDIC has apparently decided not to wait to see if Congressman Frank’s TARP Reform and Accountability Act becomes law, and has published a one page Financial Institution Letter on January 12, 2009 calling for state nonmember banks to monitor their use of capital injections, liquidity support and/or financing guarantees obtained through the recent government financial stability programs.
The FDIC notes that in exchange for government funds, capital and guarantees being used to support banking institutions, “banks are expected to document how they are continuing to meet the credit needs of creditworthy borrowers,” and reference the Interagency Statement on Responsible Lending. (As a reminder, the Interagency Statement applies to all financial institutions, and not just those that have participated in the government financial stability programs.) The FDIC expects that state nonmember banks will deploy any funding received from these programs to “prudently support credit needs in their market and strengthen bank capital.”
Potentially in response to the political and public criticism of whether the government financial stability programs are working, the FDIC calls for state nonmember banks to: (a) implement a process to document how these funds were used; and (b) to describe their utilization during bank examinations. Moreover, banks are encouraged to summarize such information in published annual reports and financial statements in order to “provide important information for shareholder and public evaluation of participation in these programs.”
Last week, the federal government provided several updates on the status of the Troubled Asset Relief Program: the Third Tranche Report to Congress (December 2nd); a speech by SEC Chairman Cox (December 4th); the first Section 105(a) Report to Congress (December 5th); and a speech by Treasury Interim Assistant Secretary Kashkari (December 5th). We have highlighted the more important components of each update below.
Third Tranche Report to Congress
The Third Tranche Report to Congress provides the basic factors that the Treasury will use in analyzing whether an institution should be supported under the Systemically Significant Failing Institutions (SSFI) Program. It was under the SSFI Program that Treasury closed a $40 billion transaction with AIG on November 26, 2008. Participation in the SSFI Program will continue to be on a case-by-case basis, based on these and other factors:
- The extent to which the failure of an institution could threaten the viability of its creditors and counterparties because of their direct exposure to the institution.
- The number and size of financial institutions that are seen by investors or counterparties as similarly situated to the failing institution, or that could otherwise be likely to experience indirect contagion effects from the failure of the institution.
- Whether the institution is sufficiently important to the nation’s financial and economic system that a disorderly failure would, with a high probability, cause major disruptions to credit markets or payments and settlement systems, seriously destabilize key asset prices, significantly increase uncertainty or losses of confidence thereby materially weakening overall economic performance.
- The extent and probability of the institution’s ability to access alternative sources of capital and liquidity, whether from the private sector or other sources of government funds.
It seems unlikely that the Treasury will include any financial institutions other than the largest ones in the SSFI Program, unless an institution can make a strong case that its stability is critical to the overall stability of the nation’s financial and economic system.
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On November 12, 2008, the FDIC, Federal Reserve, OTS, and OCC jointly issued an Interagency Statement on Meeting the Needs of Creditworthy Borrowers. This new release is a broad statement that covers both lending practices and restructuring mortgages and addresses dividend policies and executive compensation. We encourage every bank CEO to carefully review this Interagency Statement as an initial glimpse into the direction that the federal banking regulators appear to be headed.
As we’ve previously noted in our commentary, we believe that any future regulations will be placed on the industry as a whole and not merely on those that participate in the TARP Capital program. We believe this Interagency Statement lends credence to our position. While the Interagency Statement initially notes the Treasury’s program to make new capital widely available, the Interagency Statement provides that “it is imperative that all banking organizations and their regulators work together to ensure the needs of creditworthy borrowers are met,” and that “each individual banking organization needs to ensure the adequacy of its capital base, engage in appropriate loss mitigation strategies and foreclosure prevention and reassess the incentive implications of its compensation policies.”
For bankers already planning to participate in the TARP Capital program, this Interagency Statement may provide some guidance (and comfort) as to what the regulators will expect regarding expansion of the flow of credit and modification of residential mortgages.
For bankers who were not planning to participate in the TARP Capital program, this Interagency Statement may lead to a reconsideration of the relative risks of participating versus not participating.
While the Treasury Department has emphasized that it is allowing institutions to individually announce pre-approval of TARP Capital, Section 114(a) of EESA requires public disclosure of the completion of such purchases within two business days of the actual purchase. (This is also confirmed in the Treasury’s FAQ, which provides “Treasury will provide electronic reports detailing any completed transactions, as required by the Emergency Economic Stabilization Act of 2008, within 48 hours.”)
The Treasury Department has now begun publicly announcing completed transactions. As of October 29, 2008, the Treasury Report on Transactions listed only the original “Big 9.”
Read more about confidential treatment requests!
We have been speaking with all of the regional Southeastern federal banking regulators, and we have received significant input on the TARP Capital Application Process. (Institutions in other areas of the country should confirm the advice with their corresponding federal regulators; we have no reason to believe the advice will be different, but have only talked with the regulators located in the Southeast.)
Submission of Application
- Bank holding companies should submit their application to the Federal Reserve, with a copy to the primary federal regulator for their lead (i.e. largest) subsidiary bank. The Federal Reserve intends to defer decisions on any shell holding companies to the primary federal regulator of the lead subsidiary bank.
- The Federal Reserve (at least Atlanta) requests that applications be emailed to them, with a signed hard copy to follow. Processing will begin upon receipt of the emailed application.
- Applications to the Atlanta Federal Reserve should be emailed to Ms. Nicky Hennings (nicky.hennings@atl.frb.org) with a copy to Ms. Kate Gaboardi (kate.gaboardi@atl.frb.org). The hard copy should be sent in accordance with standard Atlanta Federal Reserve rules.
- Applications to the FDIC should also be emailed, based on the state of the institution’s primary office:
- State banks should also carbon copy their state banking Commissioner. The Commissioners are taking an active and helpful role in supporting the Capital Process and Regional FDIC and Fed (for member banks) have indicated an intent to communicate with State Commissioners before making a recommendation to the Treasury.
- Applications for all national banks should be emailed to HQ.Licensing@occ.treas.gov, with questions directed to Fred Finke at fred.finke@occ.treas.gov.
- Applications for federal thrifts and their holding companies must be submitted to OTS through secure e-mail. The Atlanta contact person is Yashica Pope at yashica.pope@ots.treas.gov, with copies to the Review Examiner or AD for the institution.
Supplemental Information with Application
- The Atlanta office of the FDIC advised that they are following up with each applicant when additional information (beyond the application) is necessary. Whether additional information is necessary, and the contents of such information, may vary by applicant. The FDIC advises banks to file the application without supplemental information, and the FDIC will subsequently contact the institution regarding what additional information is needed. Update 10/29/08: See the supplemental spreadsheet requested by the FDIC.
- If you have supplemental information ready to submit with your application, we do not believe there is any harm in doing so, but it is not required as part of the application. Should the supplemental information be lengthy, it may be better to state that such information is available upon request.
- The regulators are divided as to whether the application should be submitted in draft and/or with a confidential treatment request, and whether the application is subject to the Freedom of Information Act.
- Until concrete guidance is given, and potentially even then, we recommend that applications be submitted in draft form (especially for private companies that do not anticipate participating under the terms of the public term sheet) and with a confidential treatment request for any confidential information. See more information about requesting confidential treatment.
- We do recommend that counsel review the application before submission to include suggested improvements that may be available.
CAMELS Ratings and TARP Capital
- The federal regulators unanimously told us that institutions should not forego an application regardless of their CAMELS ratings.
- The Atlanta FDIC gave us the following framework that it would use for analyzing TARP applications:
- CAMELS rating 1 or 2 – Submit the application saying that you hope to make prudent loans and are available to consider problem banks, if appropriate.
- CAMELS rating 3 – Justify the long-term viability of the institution. Viability means the ability to earn money operationally (pre-tax and pre-provision, a.k.a. “Pre-Pre” earnings) and be able to survive.
- CAMELS rating 4 – Justify the long-term viability of the institution, with viability including new capital and a new business plan.
- CAMELS rating 5 – Justify the long-term viability of the institution, which includes all of the above plus new management.
- The FDIC stated that this breakdown was designed to be an example of the kind of analysis that the FDIC will perform.
- We believe that 3′s will generally be eligible and treated closer to 1′s and 2′s, while 4′s and 5′s may also be eligible given the right circumstances.
- In an acquisition, both the acquirer and acquiree can receive TARP Capital up to 3% of their respective risk weighted assets.
- The regulators all said that CRE concentrations are not a bar to receiving TARP Capital, assuming the institution has long-term viability, as discussed above. They specifically mentioned an institution which had 600% of capital in CRE, which had reduced its CRE concentration to 400% and had plans to reduce CRE to 200% over time, and suggested that the institution would be eligible for TARP Capital.
Private Company Term Sheet
- We have heard rumors of drafts of private company term sheets floating around, but can confirm that nothing has been finalized. The Conference of State Bank Supervisors is meeting daily with the Treasury and told us today that they had not seen a term sheet.
Regulators Issue Statement on Lending to Creditworthy Small Businesses
On February 5, 2010, the federal banking regulators and the Conference of State Bank Supervisors issued an Interagency Statement on the Credit Needs of Creditworthy Small Business Borrowers. The Statement builds upon principles set forth in the October 2009 Policy Statement on Prudent Commercial Real Estate Loan Workouts. After noting the overall decline in loans to small businesses and the reasons for that decline the regulators suggested that lenders may have become overly cautious with respect to small business lending. They encourage lenders to engage in prudent small business lending and that that examiners will not criticize lenders for working in prudent and constructive manner with small businesses.
The decline in small business lending has many reasons, not the least of which is that loan demand is actually down. Lenders are also naturally cautious of lending to those businesses that are reliant solely on cash flow that has slowed due to the slowdown in consumer spending and the decline ion the personal wealth of the owners of the businesses. Despite the assertions to the contrary by the regulators, lenders are concerned that there is a disconnect between statements from Washington, DC and what actually happens in the field when examiners are onsite at financial institutions. Our experience seems to show that local federal regulators do not see any upside in being flexible when faced with making decisions about how to rate credits. Lenders are therefore naturally reluctant to maker decisions based on guidance until they see it actually implemented on the ground.