Financial Institutions and Banking

Staying Ahead of the Game

Abstract: The value of real estate collateral typically is fundamental to the value of many loan portfolios. So it’s important to stay on top of real estate value fluctuations and obtain periodic appraisals according to the rules. This article points out that lenders should understand interagency guidelines, maintain program independence, use selection criteria for valuators and become familiar with appraisal standards. The article suggests that, to ensure real estate collateral is sound, it’s important to set up an effective, efficient and comprehensive review program.

Staying ahead of the game

Review your real estate valuation program

The value of real estate collateral is likely fundamental to the value of your loan portfolios. So it’s important to stay on top of real estate value fluctuations and obtain periodic appraisals according to the rules. You also need to understand interagency guidelines, maintain program independence, use selection criteria for valuators and become familiar with appraisal standards. Doing all this can keep you ahead of the game.

What are the interagency guidelines?

Start your evaluation by revisiting the kingpin of any valuation program, the Interagency Appraisal and Evaluation Guidelines. They apply to appraisals and evaluations for all real estate–related financial transactions originated or purchased by regulated institutions, whether for the institutions’ own portfolios or as assets held for sale. The guidelines cover residential and commercial mortgages, capital markets groups, and asset securitization and sales units.

Most transactions valued at more than $250,000 require appraisals, though certain transactions — listed in Appendix A to the guidelines — are exempt. In addition to the exclusion for transactions at or below the $250,000 threshold, exceptions include:

• Business loans secured by real estate for less than $500,000 (the $500,000 limit for commercial loans took effect on April 9, 2018) whose source of repayment is from other than the rental income or sale of the real estate,
• Extensions of existing credits,
• Loans not secured by real estate, and
• Transactions guaranteed or insured by the U.S. government.

The exemptions are limited, so be sure to scrutinize transactions to determine whether risk factors or other circumstances make an appraisal necessary. Some exempt transactions require a less formal evaluation.

Is your program independent?

Your institution is responsible for developing an effective collateral valuation program. First, consider the independence of your program, which should be isolated from influence by your loan production staff. Individuals who order, review and accept appraisals or evaluations should have reporting lines independent of the production staff as well. Appraisers and individuals performing evaluations (“evaluators”) need to be independent of loan production and loan collection and obviously should have no interest in the transaction or property.
Special rules apply to smaller institutions that lack the staff needed to separate their collateral valuation programs from the production process. For mortgages and other loans secured by a principal dwelling, review amendments to Regulation Z that impose strict independence and conflict-of-interest requirements on appraisers.

What are the selection criteria for valuators?

Next consider how you select valuators. Set criteria for selecting, evaluating and monitoring appraisers and evaluators, and for documenting their credentials. Among other things, ensure that those selected are qualified, competent and independent and that appraisers hold appropriate state certifications or licenses.
Select and engage appraisers directly (though appraisals prepared for other institutions may be used if specific rigorous requirements are met). Approved appraiser lists are permitted, provided you establish safeguards to ensure that list members continue to be qualified, competent and independent.

What are the minimum appraisal standards?

Then make sure that your appraisals conform to the Uniform Standards of Professional Appraisal Practice, although safe and sound banking practices may call for stricter standards. Written reports should provide sufficient detail — according to the transaction’s risk, size and complexity — to support the credit decision.

Appraisers should analyze appropriate deductions and discounts (detailed in Appendix C of the guidelines) for proposed construction or renovation, partially leased buildings, non-market lease terms and tract developments with unsold units.

What are some other factors?

In addition to these touchstones, your program should facilitate credit decisions by ensuring the timely receipt and review of appraisal or evaluation reports. It also should provide criteria for determining whether existing appraisals or evaluations may be used to support subsequent transactions.

Moreover, your valuation program should have in place internal controls that promote compliance. And it should contain standards for monitoring collateral values and for handling transactions not otherwise covered by appraisal regulations.

If you outsource valuation functions, your institution remains responsible for all appraisals and evaluations. The interagency guidelines discuss the resources, expertise, controls and due diligence procedures your institution needs to identify, monitor and manage risks associated with these outsourcing arrangements.

Is it working?

The only way to ensure that your real estate collateral is sound is to set up an effective, efficient and comprehensive program. You’ll also need to review it regularly and adjust as needed to keep it on the right track.

© 2019

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What Does the New Lease Accounting Standard Mean for Banks?

Abstract: The Financial Accounting Standards Board’s new lease accounting standard takes effect this year for public business entities — and fiscal years beginning after December 15, 2019, for other organizations. The new standard may affect banks in two ways: First, it will cause many customers’ balance sheets to swell, which may cause some customers to violate loan covenants. Second, it will have an impact on banks’ own balance sheets, which may affect their capital ratios. This article discusses the ins and outs of the new standard, while a sidebar explains how to add flexibility to loan covenants.
What does the new lease accounting standard mean for banks?
The Financial Accounting Standards Board’s (FASB’s) new lease accounting standard, nearly 13 years in the making, finally takes effect this year for public business entities — and fiscal years beginning after December 15, 2019, for other organizations. By eliminating off-balance-sheet treatment for most operating leases, the new standard may affect banks in two ways: First, it will cause many customers’ balance sheets to swell, which may cause some customers to violate loan covenants. Second, it will have an impact on banks’ own balance sheets, which may affect their capital ratios.
A brief refresher
Under the previous lease accounting standard, leases were classified either as “capital” or “operating” leases. Generally, capital leases transfer ownership of assets to the lessee, while operating leases transfer the right to use assets during the lease term. Capital leases are reported on the balance sheet, but operating leases are not — though they’re disclosed in the financial statement footnotes.
The new standard retains the distinction between operating and capital leases (now called “finance” leases), but requires all leases, other than short-term operating leases (those with terms under one year), to be reported on the balance sheet. For each lease on the balance sheet, a lessee will record 1) a liability reflecting its obligation to make lease payments, and 2) an asset reflecting its legal right to use the leased property (a “right-of-use” or ROU asset). Both are based on the present value of minimum payments under the lease, with adjustments to the ROU asset for certain prepayments, incentives and costs.
Expense recognition under the new standard depends on a lease’s classification. For finance leases, organizations amortize the ROU asset, generally on a straight-line basis, and recognize interest expense and liability repayment over the life of the lease, similar to a loan. For operating leases, organizations generally recognize lease expenses on a straight-line basis, with certain adjustments.
Impact on loan covenants
As the new standard takes effect, borrowers with significant operating leases will experience an immediate increase in assets and liabilities on their balance sheets. As a result, some loan customers may be in technical violation of loan covenants that place limits on their overall debt or require them to maintain certain debt-related financial ratios. Banks should review all loan covenants to evaluate the impact of the new standard.
Whether it will have an adverse impact on borrowers depends in part on how “debt” is defined in the loan documents. The FASB, recognizing that the new standard might create issues with loan covenants, provided for operating lease liabilities to be characterized as “operating liabilities,” rather than “debt.” This action should prevent violations of some commonly used loan covenants. However, covenants that rely on financial ratios that include operating lease liabilities may present a problem.
Banks should consider modifying existing loan covenants to avoid unnecessary breaches and revise covenants going forward to reflect the new lease accounting standard. (See “Adding flexibility to your loan covenants.”) It’s important to recognize that the addition of operating leases to the balance sheet doesn’t change a borrower’s underlying economic situation, cash flow or ability to repay a loan. After all, in most cases, the borrower has been making these lease payments for years — the new standard merely changes the way they’re reported.
Impact on bank capital
For most community banks, the new lease accounting standard isn’t likely to have a significant impact on regulatory capital. But it may affect some banks with substantial operating leases for facilities, equipment and other fixed assets.
This is because the addition of ROU assets to the balance sheet may affect the ratio of capital to risk-weighted assets. The ratio is used to determine capital adequacy.
Some recommendations
All banks should review their loan documents and modify them if necessary to prevent inadvertent violations of loan covenants. They should also assess the impact of the new standard, if any, on their regulatory capital levels.

Sidebar: Adding flexibility to your loan covenants
The new lease accounting standard demonstrates how changes in financial reporting can affect compliance with loan covenants, even if the underlying economics are the same. As you review existing loan documents and negotiate new ones, consider incorporating covenant models that provide the flexibility needed to adapt to future changes in Generally Accepted Accounting Principles (GAAP). Two common approaches are:
1. Frozen GAAP. Covenants that contain a frozen GAAP clause provide that changes in financial ratios resulting from changes in GAAP won’t cause a violation. In other words, applicable GAAP is frozen as of the date the loan is made. The problem with this approach is that continuing to apply GAAP that’s in effect at the time the loan agreement is executed, regardless of future changes, essentially requires two sets of books: one to comply with GAAP and one to track compliance with loan covenants.
2. Semifrozen GAAP. A semifrozen GAAP clause requires the parties to renegotiate the loan covenant if a change in GAAP alters financial ratios. This approach avoids the need to keep two sets of books. But it requires the parties to amend the covenant to accommodate their respective needs while reflecting changes in GAAP.
© 2019

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Beware the Ides of March — if you own a pass-through entity

Shakespeare’s words don’t apply just to Julius Caesar; they also apply to calendar-year partnerships, S corporations and limited liability companies (LLCs) treated as partnerships or S corporations for tax purposes. Why? The Ides of March, more commonly known as March 15, is the federal income tax filing deadline for these “pass-through” entities.

Not-so-ancient history

Until the 2016 tax year, the filing deadline for partnerships was the same as that for individual taxpayers: April 15 (or shortly thereafter if April 15 fell on a weekend or holiday). One of the primary reasons for moving up the partnership filing deadline was to make it easier for owners to file their personal returns by the April filing deadline. After all, partnership (and S corporation) income passes through to the owners. The earlier date allows owners to use the information contained in the pass-through entity forms to file their personal returns.

For partnerships with fiscal year ends, tax returns are now due the 15th day of the third month after the close of the tax year. The same deadline applies to fiscal-year S corporations. Under prior law, returns for fiscal-year partnerships were due the 15th day of the fourth month after the close of the fiscal tax year.

Avoiding a tragedy

If you haven’t filed your calendar-year partnership or S corporation return yet and are worried about having sufficient time to complete it, you can avoid the tragedy of a late return by filing for an extension. Under the current law, the maximum extension for calendar-year partnerships is six months (until September 16, 2019, for 2018 returns). This is up from five months under the old law. So the extension deadline is the same — only the length of the extension has changed. The extension deadline for calendar-year S corporations also is September 16, 2019, for 2018 returns.

Whether you’ll be filing a partnership or an S corporation return, you must file for the extension by March 15 if it’s a calendar-year entity.

Extending the drama

Filing for an extension can be tax-smart if you’re missing critical documents or you face unexpected life events that prevent you from devoting sufficient time to your return right now.

But to avoid potential interest and penalties, you still must (with a few exceptions) pay any tax due by the un-extended deadline. There probably won’t be any tax liability from the partnership or S corporation return. But, if filing for an extension for the entity return causes you to also have to file an extension for your personal return, it could cause you to owe interest and penalties in relation to your personal return.

We can help you file your tax returns on a timely basis or determine whether filing for an extension is appropriate. Contact us today.

© 2019