What are bankers’ biggest challenges with FAS 114 impairment analyses?
In calculating the ALLL, often one of most cumbersome components of the process proves to be the FAS 114 (ASC 310-10-35) impairment analysis. Instead of being grouped into homogenous pools like their FAS 5 (ASC 450-20) counterparts, these loans are segmented out as having evidence of impairment and then calculated individually to determine expected loss. This process can be both time consuming and complex.
In a December 2014 webinar, How to Calculate Your FAS 114 Reserves, Sageworks polled bankers to determine which facets of the FAS 114 calculation present the greatest challenge.
The first poll asked about obstacles using the fair market value of collateral method to value a collateral-dependent loan:
Bankers cited that maintaining an updated appraisal, with twice the responses of any other option, causes the most trouble in using the fair market value of collateral methodology.
Guidance does not mandate a concrete time-frame in which appraisals should be updated, but it does call for periodic updates. Many industry professionals advise institutions to update these appraisals on at least an annual basis; examiners are less likely to dispute the appraisal’s validity if it’s twelve months or fewer from the examination date, barring no extenuating circumstances.
With that said, few institutions have the time or resources to ensure all appraisals are “current” or completed on an annual basis. If getting an updated appraisal is not a possibility, there are (admittedly not as comprehensive) alternatives to satisfy the demands of fair market value of collateral valuations.
Making updates, such as discounts, to older appraisals can serve institutions in this process if the updates are well-documented and thorough. Some institutions have automated processes in place in which discounts are applied to all real estate loans after 18 months, and other variations of discounts are applied to non-real estate loans. Again, there is no mandatory time window nor magic discount rate that will ensure the appraisal is timely and accurate. Rather, it’s important the institution demonstrates a structured process that will ensure consistency, and that the institution documents the process thoroughly to maintain transparency during the exam.
The next poll pertained to the present value of future cash flow valuation method in the impairment analysis. Respondents indicated that determining and justifying expected monthly payments is the most troublesome part of this method, followed by determining when to generate a balloon payment in the cash flow schedule.
This first challenge, determining and justifying expected monthly payments, should come as no surprise. Examiners will undoubtedly require institutions to show evidence of borrowers’ capacity to meet the calculated monthly payment schedule.
As a first step, the institution should verify it has updated financial information for the borrower, including the revised amortization schedule if pertinent, and document the negotiation process through which an end monthly payment was determined. An examiner will not take John Doe at his word that he is capable of fulfilling a $3,200 monthly payment, but if an institution can prove that John’s cash flow includes an expendable $3,900 per month and that he has a longstanding history of making payments before the loan became impaired, the bank will be in a much better position to justify its assumptions.
Next, institutions cited challenges with determining when to use a balloon payment in the cash flow schedule. Inclusion of a balloon payment is determined using the possibility of whether such a payment is viable and expected. Take for instance the example of John, above. If the original terms of the loan required monthly payments of $5,000 before his loan became impaired, but he temporarily lost an income stream and was forced to reduce his payments to $3,200, first vet out whether or not a balloon payment is possible. Is John’s income stream impaired indefinitely, or did he simply run into cash flow issues? If we know he is expected to receive a settlement of $100,000 in 12 months (or his income stream that previously dried up is expected to be renewed), then it is in the interest of both parties to schedule a balloon payment. Again, document the negotiation process and have his updated financial information to defend your assumptions when examiners question how he will be able to make the balloon payment of $40,000.
Although the FAS 114 portion of the ALLL calculation brings with it various challenges, institutions can mitigate these difficulties by creating structured processes and by bolstering documentation procedures. For more on FAS 114s and the process of calculating impairments, download the whitepaper: How to Calculate Your FAS 114 (ASC 310-10-35) Reserves or access the FAS 114 Impairment Analysis Worksheet.