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Action Matters

Effectively Facing a Government Enforcement Action

With the lingering recessionary economy, high unemployment and depressed real estate markets, many U.S. banks have been placed under some form of regulatory enforcement action, as asset quality deteriorated. Consequently, such actions by the FDIC, OCC or Federal Reserve and State Banking authorities place a significant responsibility on management and the board of directors (BOD) to take corrective action to improve the overall condition and operations of the bank. Full compliance with a consent order or other regulatory actions is imperative and should be an essential mandate of the bank’s management and BOD.

As of June 30, 2011, 865 banks nationwide – 11.5 percent of 7,513 insured depository institutions – were on the FDIC’s problem bank list, representing total assets of $372 billion. In addition, during the same period, non-accruing loans and loans more than 90 days past due represented 4.37 percent of total loans in FDIC insured institutions.

In those institutions with asset quality issues, one of the key elements of the action or order is the requirement for management to prepare, and BOD or a designated committee to review and approve, Criticized Asset Reports (also known as CARs) on a monthly or quarterly basis. These reports are generally required for all loans or relationships over a specified dollar amount that have been criticized as Special Mention, Substandard or Doubtful by the regulatory authority, management or internal or external loan review. The enforcement action document provides a roadmap for the information that should be included in the CARs to aid in compliance with regulatory expectations.

Getting it Right

The report should reflect management best practices for problem loan oversight, risk rating accuracy, effective loan workout plans, loan policy adherence and timely problem loan identification. In addition to meeting regulatory requirements, CARs can serve as a useful management tool to monitor risk rating accuracy and the effectiveness of the bank’s problem loan management program. The following are critical elements that will enhance the effectiveness of CARs and, in turn, achieve the necessary regulatory approval and concurrence:

• Provide the names of the originating officer and the current servicing officer.
• Include a detailed discussion of the relationship background and the basis for the criticism.
• Detail the current regulatory and bank assigned risk rating and the date of the most recent rating change.
• List pertinent structural and performance history including terms and conditions of the loan, amount, origination date, renewals and payment history, accrual status, and primary and secondary sources of repayment.
• Provide a thorough analysis of pledged collateral, if any, and the actions management is taking to protect the bank from loss exposure, including a discussion of the most recent appraisal or valuation of the collateral. Real estate projects should include current status, occupancy, rental or sales activity and debt service coverage. For rental properties, current rents and occupancy should be compared to the market and the projections in the most recent appraisal.
• Detail conformity with the bank’s lending policy and any loan agreement including financial and other covenants, borrowing base stipulations and financial reporting.
• Note if the loan meets the criteria for a Troubled Debt Restructure (TDR) or if it is considered impaired. Should the loan be considered impaired, a discussion of the impairment analysis should be included with a description of the valuation approach.
• Include a thorough discussion of the bank’s plan for removing the asset from criticism or an exit strategy. The plan must be comprehensive and have specific performance goals and objectives with a timeline that is monitored and updated regularly. The performance goals and timelines should be clearly communicated to the borrower in a written work out plan. The written workout plan gives both the borrower and the bank a roadmap for possible rehabilitation of the loan relationship. If legal action has commenced, summarize the current status. Management should also consider a contingency plan should the original workout plan not proceed as expected.
• Provide a complete analysis of the borrower and any guarantors including comprehensive cash flow analysis and global cash flow – updating it with the most current financial information. The analysis also should include contingent liabilities and verification of liquidity.
• Discuss any new advances of funds to a criticized or classified borrower. The new advance should be based on a thorough financial and collateral analysis, justify why it promotes the bank’s best interests and be approved by the proper level of authority called for in the regulatory action.

Finalizing the Report

Once the initial CAR is prepared it should be reviewed, revised, if necessary, and approved by a designated management committee. When the report is finalized, it should be presented to the designated board committee along with an executive summary of the bank’s asset quality risk profile. This risk profile should include, at a minimum, target benchmarks as a percentage of assets or capital for past due loans, non-performing assets, other real estate owned, and classified and criticized assets.

The CAR must be updated regularly with the most current information for the borrower and / or guarantor included. Any updates to the initial report must contain information pertaining to its current status, adherence to the workout plan, loan policy compliance, and time table and prospects for eliminating of the sources of criticism. Other real estate owned assets should be handled in a similar manner and conform to laws, regulations and regulatory guidelines, including 12 U.S.C. 29, and 12 C.F.R. Part 34, Subpart C & E and 12 C.F.R. 34.85. CARs for each property should be prepared that reflect:

• A complete description of the property along with a current condition report.
• The foreclosure date and the identity of the bank officer(s) responsible for managing and authorizing transactions relating to the property.
• Appraised value with the date of the most recent appraisal, the identity of the appraiser and the methodology used. Property values should be carried on the bank’s books in accordance with the current Call Report instructions.
• An analysis of the property that compares the cost to carry against the financial benefits of a near-term sale.
• A current rent roll, occupancy report and cash flow if the property is income producing.
• A current status report and completion budget if the property is under construction or a status report, cost to complete and sales activity report, if the property is a land development.
• The property’s marketing plan, the documented efforts to sell and a targeted time frame for disposing of the property.
• An exit strategy for each property and updated significant developments.

Conclusion

The development of Criticized Asset Reports is a fundamental requirement of regulatory enforcement actions and is also a useful tool for management and BOD to monitor the bank’s progress in addressing asset quality issues. To attain the needed regulatory approval and provide for the appropriate detail, everyone must give the CARs program their full support. Success will also rest on management’s ability to instill officer accountability and reflect conformance in performance evaluations and compensation.

Michael Moser, Senior Director, is the author of this story.