I. Transferring
an Asset to OREO Q1.
When should
an institution re-categorize its asset from “Loans and lease financing
receivables” to “Other real estate owned” on the Consolidated Reports of Condition and Income
(Call Report)?2A1. In accordance with Call Report instructions,
an institution should re-categorize its asset from “Loans and
lease financing receivables” to “Other real estate owned”
on the Call Report when the institution takes physical possession
of the property, regardless of whether formal foreclosure proceedings
have taken place.
Q2. At what value should
an institution initially report an OREO asset?
A2. In accordance with Call Report instructions, when an institution
receives an asset, such as real estate, from a borrower in full satisfaction
of a loan, the institution initially reports the asset at its fair
value less cost to sell.
3 Similarly, a real estate asset received
in partial satisfaction of a loan should be initially reported as
described above and the carrying amount of the loan should be reduced
by the fair value less cost to sell of the asset at the time of foreclosure.
4 The fair value less cost to sell becomes the “cost”
of the OREO asset. The amount, if any, by which the carrying amount
of the loan plus recorded accrued interest (that is, the recorded
loan amount) exceeds the fair value less cost to sell of the OREO
asset is a loss that must be charged to the allowance for loan and
lease losses (ALLL) at the time of foreclosure or repossession.
If the fair value less cost to sell of the OREO asset
when taken into possession is greater than the recorded loan amount,
the excess should be reported either as “Other noninterest income”
on the Call Report or as “Recoveries on loans and leases”
if there had been a prior charge-off of the loan. In a situation when
the OREO asset appears to be worth more than the balance of the loan,
the appraisal or other information on the property’s value should
be reviewed to understand why the borrower would risk losing the equity
in the property. Additionally, in some states, lenders are required
to return recovered amounts, in excess of the amount owed, to the
borrower.
Q3. Do Call Report requirements
differ when a borrower has the ability to redeem a property after
foreclosure?
A3. Reporting requirements
will depend on who has physical possession of the property after foreclosure.
If state law allows the borrower to live in the property during the
redemption period, then the asset would remain in “Loans and
lease financing receivables” on the Call Report until expiration
of the redemption period and the institution takes physical possession
of the property. However, if the institution has physical possession
of the property during the redemption period (that is, the borrower
has vacated the property or has been evicted from the property), then
the asset would be moved to “Other real estate owned”
on the Call Report.
II. Reporting
Treatment and Classification Q4. When an institution forecloses on its subordinate lien position,
how are the outstanding senior liens on the OREO asset treated for
financial reporting purposes?
A4. In accordance
with Call Report instructions, the amount of any senior debt (principal
and accrued interest) to which an OREO asset is subject at the time
of foreclosure is reported as a liability in “Other borrowed
money” on the Call Report.
Q5. What
are the reporting consequences when the value of an OREO asset changes?
A5. In accordance with Call Report instructions,
an OREO asset is carried at the lower of (1) the fair value of the
asset less the estimated cost to sell the asset or (2) the cost of
the asset (that is, the OREO asset’s fair value less cost to
sell recorded at the time of foreclosure, as discussed in Question
2).
Changes in fair value must be determined on each OREO
asset individually. In subsequent periods, if the fair value of the
OREO asset minus the estimated cost to sell is less than the cost
of the asset, the deficiency must be recognized as a valuation allowance
against the asset, which is created through a charge to expense. This
valuation allowance is increased or decreased (but not below zero)
through charges or credits to expense for changes in the OREO asset’s
fair value or estimated selling cost. On the Call Report, the balance
reported for the OREO asset is net of any valuation allowances.
Q6. Should an OREO asset be adversely classified?
A6. As discussed in the “Classification
of OREO,” subsection of section 2200.1 “Other Real Estate
Owned” of the Commercial Bank Examination Manual, an
OREO asset is generally considered an adversely classified asset.
For purposes of classification, any carrying value of the OREO asset
in excess of its fair value, less cost to sell, should be classified
as Loss, net of any applicable valuation allowance. The institution
should periodically evaluate the OREO asset’s carrying value
and factors affecting potential recovery that may require classification
of the asset’s remaining book value.
In determining the classification of the remaining book
value, an institution may consider a pending sale of the OREO asset
or rental income from the OREO asset. If the institution has a sales
contract to sell the OREO asset to a third party and the net sale
proceeds are expected to cover the carrying value, the institution
may not need to classify the asset. The institution should be able
to demonstrate that the purchaser has the financial resources to complete
the purchase and that the institution has no contingent liability
to repurchase the property or guarantee the property’s financial
performance.
With regard to residential rental OREO properties, a property
with a lease in place and demonstrated rental cash flow sufficient
to generate a reasonable rate of return would generally not be adversely
classified. For further guidance, refer to SR letter 12-5/CA letter
12-3, “Policy Statement on Rental of Residential Other Real
Estate Owned (OREO) Properties.”
Q7. How should an institution report the operating income and expenses
for an OREO asset on the Call Report?
A7. Operating
income related to an OREO asset (for example, gross rental income)
is recognized as “Other noninterest income” on the Call
Report, while expenses are reported as “Other noninterest expense.”
Operating expenses include, but are not limited to, legal fees and
direct costs incurred for foreclosure, property maintenance, and state
and local government assessments.
Q8. How does an institution account for real estate taxes and insurance
on an OREO asset?
A8. In accordance with
generally accepted accounting principles (GAAP), real estate taxes
and insurance would be expensed if the institution is merely holding
the property for future sale. If an institution forecloses on an incomplete
project and decides to complete construction, costs incurred for real
estate taxes and insurance are capitalized during the construction
period until it is substantially complete and ready for its intended
use. Once the OREO asset is substantially complete and ready for its
intended use, those costs are expensed.
Q9. If an OREO asset is partially completed and the institution decides
to complete construction, how should the institution report these
capital improvement expenses?
A9. In accordance
with GAAP, capital improvement expenses clearly associated with the
construction of the project should be capitalized as part of the cost
of the OREO asset and reported on the balance sheet as part of the
fair value less cost to sell of the asset. Once the property is ready
for its intended purpose, subsequent carrying costs should be expensed
as incurred. As noted in Question 5, each OREO asset must be carried
at the lower of (1) the fair value of the asset less the estimated
cost to sell the asset or (2) the cost of the asset. Therefore, while
the capital improvements will increase the cost of the asset, the
capitalized expenses may not increase the OREO asset’s recorded
value to an amount greater than the asset’s fair value after
improvements and less cost to sell.
III. Appraisal Concepts5 Q10. What are the Federal Reserve’s supervisory
expectations for a regulated institution’s practices to obtain
an appraisal upon a property’s transfer to OREO?
A10. In accordance with the regulatory appraisal
exemption for an existing extension of credit in the Federal Reserve
Board’s appraisal regulation,
6 a regulated institution is required
at minimum to obtain an evaluation when a property is transferred
to OREO through foreclosure or a deed in lieu of foreclosure. Although
the appraisal regulation’s minimum requirement is an evaluation,
the regulated institution may decide to obtain an appraisal, considering
the type, complexity, use, and location of the property, as well as
current market conditions. Refer to SR letter 10-16, “Interagency
Appraisal and Evaluation Guidelines,” for a discussion of the
development and content of an evaluation. While the Federal Reserve
Board’s regulation may not require an appraisal, a state member
bank also needs to consider whether state banking laws and regulations
require an appraisal at the time the state member bank forecloses
or takes possession of the property. Refer to SR letter 95-16, “Real
Estate Appraisal Requirements for Other Real Estate Owned (OREO).”
Q11. What are the supervisory expectations
for an institution’s practices to determine the value of a property
upon transfer to OREO?
A11. In accordance
with the Board’s appraisal regulation, an institution must,
at a minimum, have an evaluation or may elect to obtain an appraisal
to determine the value of a property upon transfer to OREO. The evaluation
or appraisal should reflect an opinion of the property’s market
value as defined in the Board’s appraisal regulation (12 CFR
225.62 (g)). Market value is defined as:
The most probable price which a property
should bring in a competitive and open market under all conditions
requisite to a fair sale, the buyer and seller each acting prudently
and knowledgeably, and assuming the price is not affected by undue
stimulus. Implicit in this definition are the consummation of a sale
as of a specified date and the passing of title from seller to buyer
under conditions whereby:
(1) Buyer and seller are typically
motivated;
(2) Both
parties are well informed or well advised, and acting in what they
consider their own best interests;
(3) A reasonable time is allowed
for exposure in the open market;
(4) Payment is made in terms of
cash in U.S. dollars or in terms of financial arrangements comparable
thereto; and
(5) The price represents the normal consideration for the property
sold unaffected by special or creative financing or sales concessions
granted by anyone associated with the sale.
The term “market value” that is defined in
the Board’s appraisal regulation is based on similar valuation
concepts as “fair value” for accounting purposes under
GAAP. In accordance with GAAP, the term “fair value” reflects
the price that would be received to sell an asset in an orderly transaction
between market participants at the measurement date. Therefore, to
comply with GAAP, an institution must initially report the fair value
of the property less cost to sell on its financial statements, as
discussed in Question 2.
Q12. How should
an institution assess the adequacy of an appraisal (or an evaluation
if permitted) to support its valuation of a particular OREO property?
A12. The appraisal should fully support
the market value opinion of the OREO asset with sufficient information
and analysis of the property’s current “as is” condition
(considering the property’s highest and best use) and other
relevant risk and market factors affecting the property’s market
value. This includes an assessment as to whether the appraisal’s
assumptions on market conditions, events, and trends are reasonable
and supportable. Refer to SR 10-16 for further supervisory expectations
for an institution’s appraisal process. An institution should
consider whether:
- The appraisal addresses the current condition of the
property and reflects any deferred maintenance.
- For a property under construction, construction costs
are reasonable and are adequate to cover completion of the project
in accordance with plans and any possible contingencies.
- The assumptions support any anticipated change in
the permissible use of the property, supported by information on market
conditions.
- For a special-purpose property, the appraisal considers
the value of the property under more conventional use and identifies
the value of any special-purpose features and fixtures.
- The sources of data are current and timely, recognizing
that there are data lags when public records are used.
- If there are few comparable sales, the appraisal addresses
supply and demand factors, and identifies recently closed sales and
not just properties listed for sale.
- For an income-producing property, the appraisal provides
information on and consideration of typical rental concessions.
- The holding and absorption period to achieve stabilized
occupancy or to sell-out the project are reasonable and supportable
by current market conditions and trends.
- Terms and conditions of lease renewals consider the
current market and rental rates and not just historical trends.
- On an existing property, the appraisal explains whether
contract rents differ from market rents and discloses the effect on
the property’s market value.
- Capitalization and discount rates are realistic and
reflective of current investor expectations.
Q13. What are the supervisory expectations
for an institution’s practices to monitor the value of OREO,
including obtaining a new appraisal?
A13. While
the Federal Reserve has no regulatory requirement governing when and
how often to obtain a new appraisal for an OREO asset, SR 10-16 provides
supervisory expectations that an institution should have policies
and procedures for the monitoring of collateral values. Further, current
market value information of an OREO asset is necessary to determine
the property’s fair value and support the carrying value of
the OREO asset on the institution’s financial statements. Therefore,
a regulated institution should have a policy establishing procedures
for monitoring the market value of the OREO property over the holding
period.
The institution’s policy should consider whether
the existing appraisal or collateral valuation information is still
current. The policy should consider procedures for determining the
validity of an existing appraisal or collateral valuation information,
with which to determine whether the appraisal or collateral valuation
reflect current market conditions, based on factors such as: the property
type, current market supply and demand, current use of the property,
and the passage of time since the most recent appraisal. Updated collateral
valuation information is particularly important during rapidly changing
market conditions (including both declining and improving
markets), and when there are changes in project plans.
A state member bank also needs to
consider whether state banking laws and regulations require the state
member bank to update the property’s market value on an annual
or periodic basis. These requirements vary by state and are addressed
in state regulations on the booking and holding of other real estate
or bank-owned real estate.
IV. Ongoing Property Management Q14. How long may a Federal Reserve-regulated institution
hold an OREO asset on its books?
A14. Generally,
the Federal Reserve allows bank holding companies to hold an OREO
asset for up to five years, with an additional five-year extension
subject to certain circumstances.
7 Regardless of the allowable holding period, the Federal Reserve
generally expects bank holding companies, their nonbank subsidiaries,
and state member banks to seek to dispose of OREO assets as soon as
prudent and reasonable, taking into account market conditions.
8 Under difficult market conditions, Federal Reserve regulations
and policies permit the rental of OREO properties to third-party tenants
as part of an orderly disposition strategy within statutory and regulatory
limits. For further guidance on this matter, refer to SR 12-5/CA 12-3.
Savings and loan holding companies generally may acquire
real estate for rental and are not subject to the same statutory and
regulatory restrictions as bank holding companies.
9State member banks and licensed
branches of foreign banks are subject to the holding periods and other
limitations on OREO activity established by their licensing authority,
which vary on initial holding period, extensions of holding period,
and total length of the holding period, as well as requirements for
the write-down of the OREO carrying value.
Q15. If an institution decides to enter into an agreement with a third
party to manage or maintain an OREO asset, what due diligence should
the institution’s management consider before entering into a
management agreement, and what are sound practices for entering into
and managing outsourcing arrangements for OREO activities?
A15. To manage the cost and to supplement its
own resources, an institution may use a third-party service provider
for property management, maintenance or improvements, compliance with
local laws and regulations, or other services. However, the outsourcing
of all or part of the OREO management function poses risks that an
institution needs to address, as is the case with any outsourced function.
Therefore, the supervisory guidance for managing the risks associated
with other types of outsourcing arrangements
10 may be used as guidance for sound risk management practices
for the selection, contract review, and monitoring of a third-party
provider. In entering into these third-party arrangements, an institution
should:
- Identify, assess, and monitor the risk of the outsourcing
arrangement.
- Implement policies and procedures for monitoring and
managing the risk of outsourcing OREO activities, consistent with
the institution’s OREO policies and procedures.
- Perform due diligence and evaluate vendors, considering
such factors as competence, expertise, management quality, financial
strength (for example, the ability to obtain insurance and bonding),
and professional accreditation. Other considerations include the vendor’s
experience with a particular property type or in a particular geographic
market, and presence of, or access to, specialized legal expertise.
A contractual arrangement may address the
following items:
- Expectations and responsibilities under the contract
for both parties. Among other things, vendor responsibilities should
include providing information related to the work performed, expenses,
compliance with all applicable laws and regulations, and other relevant
activity or risk-exposure information necessary for sound risk management
by senior management and directors;
- The scope and frequency of, and the fees to be paid
for, the work to be performed by the vendor;
- The process for changing the terms of the contract
or agreement, especially for expansion of work if significant repair
or maintenance issues are found, and conditions of default and causes
for contract termination;
- The location(s) where OREO activity documentation
will be maintained by the vendor, the length of time documents will
be archived by the vendor, and provisions for the institution to have
reasonable and timely access to the documents;
- Audit and regulatory review of the vendor’s
services, including stipulations that examiners have access to records
or documents prepared or maintained by the vendor; and
- A process (for example, arbitration, mediation, or
other means) for resolving disputes and for determining who bears
the cost of consequential damages arising from errors, omissions,
and negligence.
Q16. When an institution forecloses on
a partially completed real estate project, what factors should be
considered before deciding to finish the project or sell the project
in its “as is” condition?
A16. While
each situation presents varying challenges and risks, an institution
should analyze the economic cost and risk before deciding to complete
a project, considering the feasibility of the project under current
market conditions. The institution should also consider whether it
has the skill and management resources to manage a construction project.
Furthermore, an institution should evaluate whether investing additional
funds to complete the project will minimize its losses as compared
to marketing and selling the property in its “as is” condition.
Q17. What steps should institutions take
to ensure that a property is appropriately maintained after a notice
of foreclosure is issued to the current homeowner but prior to the
foreclosure being completed?
A17. Institutions
are expected to have controls to ensure compliance with state and
local laws related to entering properties during a foreclosure redemption
period. Furthermore, institutions should secure properties to the
best of their ability during the foreclosure process.
V. Operational and Legal Issues Q18. What ownership risks or liabilities
arise when an institution takes title to OREO, and what are the sound
risk management practices associated with the ownership of foreclosed
property (both occupied and vacant properties)?
A18. Based on its risk assessment, an institution should consider
seeking legal advice on the risks posed by taking possession of the
property. The risk assessment should be performed before the institution
takes title to the property and should consider local market conditions
and any local and state government requirements governing the institution’s
ownership, maintenance, and sale or disposal of the property. If the
property is located outside of the institution’s market footprint,
the institution may need to retain experts with knowledge of local
legal requirements and market conditions.
Ownership
risks and potential liability exposures include:
- Obligations under property governing documents, tenant
lease agreements, or contracts;
- Requirements to provide a safe and secure environment
to tenants;
- Requirements to maintain or operate the property
in conformance with federal, state, and local laws, including those addressing
health and safety standards;
- Payment of property taxes; and
- Obligations to address possible environmental risks.
Examples of risk management practices for vacant
properties include:
- Remediating obvious hazards to health and safety;
- Securing exterior openings to the property and all
exterior mechanical systems;
- Adjusting utility services to a level appropriate
to preserve the property;
- Scheduling the property for periodic field inspection
and maintenance;
- Posting emergency contact information and ownership
information on the main entrance door to the property, on a laminated
waterproof notice;
- Posting and executing “No Trespassing”
signage at the front and rear of the property, and executing all required
“No Trespass” documents in accordance with local law enforcement
agencies; and
- Analyzing the potential environmental liability to
the institution and the implications for the property’s value.
Q19. What are some potentially useful
measures for monitoring and managing OREO risk?
A19. An institution should develop measures to assess and monitor
the risk in its OREO assets that are consistent with the nature, extent,
and complexity of its OREO portfolio. Management should have an information
system to monitor and analyze OREO properties that is appropriate
for the institution’s OREO portfolio size and complexity.
The following are examples of performance ratios that
the institution may choose to monitor:
- Net disposition proceeds as a percentage of original
book value of the property
- Valuation reserve as a percentage of OREO values
- Volume and dollar amount of former OREO currently
being financed
- OREO holding and management costs as a percentage
of OREO
- Legal expense (since foreclosure) related to OREO
as a percentage of OREO
- OREO as a percentage of internally criticized assets
(which include special mention and classified assets) plus past due
- OREO (by type) as a percentage of corresponding loan
type
Q20. What controls and processes should
institutions have in place to ensure that properties in the OREO inventory
are properly maintained and meet local code-enforcement ordinances
and other laws?
A20. Institutions should
have policies and procedures in place to ensure that properties are
maintained in compliance with federal, state, and local laws, including
laws governing health and safety, property preservation, fair housing,
and property registration. An institution’s failure to adhere
to these legal requirements can result in fines, litigation, and reputational
damage. Further, institutions engaging third-party vendors to carry
out functions related to these requirements should ensure that vendors
maintain appropriate compliance controls. Reliance on third-party
vendors does not relieve an institution of its compliance responsibilities
or liability.
Q21. In addition to considerations
regarding health and safety violations, how should institutions determine
which repairs to make before disposition?
A21. Expending funds to repair a property is one strategy for
an institution to consider for improving potential recovery on the
sale of OREO assets. For instance, repairs may be necessary for the
property to qualify for a Federal Housing Administration (FHA)-insured
loan, which in turn may attract a greater number of qualified buyers.
Institutions should have controls in place to comply with all federal,
state, and local laws, including fair housing laws. For example, institutions
may not avoid or delay the maintenance or repairs of dwellings based
on the racial or ethnic composition of the geographic area where they
are located.
Q22. What steps
should an institution take to comply with existing laws protecting
tenants?
A22. Institutions should have
controls in place to comply with all federal, state, and local laws
related to protecting the rights of tenants, including the federal
Protecting Tenants at Foreclosure Act of 2009 (CA letter 09-5), Servicemembers
Civil Relief Act (CA letter 05-3), the Fair Housing Act, and the Americans
with Disabilities Act. For example, an institution or its agent should
have consistent processes in place to provide proper and timely notice
of the institution’s ownership of the foreclosed property and
provide the tenant with the allowable timeframes, as established under
law, to remain in the foreclosed property before eviction proceedings
commence. Institutions that lack experience as a landlord may wish
to engage the services of a property management firm. However, as
previously stated, reliance on third-party vendors does not relieve
an institution of its compliance responsibilities or liability.
VI. Sale and Transfer of
OREO Q23. What is the primary
source of accounting guidance for sales of OREO?
A23. The primary accounting guidance for sales of real estate
(including foreclosed real estate) is Accounting Standards Codification
Subtopic 360-20, “Property, Plant, and Equipment—Real
Estate Sales” (formerly FASB Statement No. 66, “Accounting
for Sales of Real Estate”) (ASC 360-20). This standard, which
applies to all transactions in which the seller provides financing
to the buyer of the real estate, establishes several methods (discussed
in questions 25 to 27) to account for the disposition of real estate.
The methods established in ASC 360-20 are the full accrual, installment,
cost recovery, reduced-profit, and deposit methods. Each of these
methods is also summarized in the Call Report Glossary entry titled
“Foreclosed Assets.”
While the methods established in ASC 360-20 are briefly
described in the questions below, this document does not contain a
comprehensive list of all considerations that need to be made when
analyzing sales of real estate. This area of GAAP is very complex
and requires significant judgment; therefore, a thorough review of
ASC 360-20 is usually required when analyzing sales of real estate
because it provides detailed guidance necessary to determine the appropriate
accounting for these transactions. As a result, it is not possible
to cover all of the details of this area of GAAP in this document.
Q24. When an institution sells an OREO asset,
how is a gain or loss on the sale reported on the Call Report?
A24. Any loss on the sale of an OREO asset
should be recognized immediately and reported as “Net gains
(losses) on sales of other real estate owned” on the Call Report.
A gain on the sale of an OREO asset is also reported on the same line;
however, recognition of a gain depends on the accounting method used
in the transaction, as noted in Questions 25-26.
Q25. When may an institution immediately recognize the gain
on an institution-financed sale of OREO?
A25. Under
GAAP, when the transaction meets the qualifications for the full accrual
method of sale accounting, the following applies: (1) a sale is recognized,
(2) the asset resulting from the institution’s financing of
the transaction is reported as a loan, (3) the gain or loss on the
sale is recognized immediately, and (4) interest income is accrued
on the new loan. This method may be used when all of the following
conditions have been met:
- A sale has been consummated,11
- The buyer’s initial investment (for example,
a cash down payment) and continuing investment (periodic payments)
are adequate to demonstrate a commitment to pay for the property,
- The receivable is not subject to future subordination,
and
- The usual risks and rewards of ownership have been
transferred.
Further details regarding the minimum initial
investment, including detailed guidance regarding what must be included
or excluded in this amount, can be found in ASC 360-20. The Appendix
to this Q&A document contains guidance on the minimum initial
investment for various types of real estate that is provided in ASC
360-20-55. To meet the continuing investment (periodic payment) requirement,
the contractual loan payments must be sufficient to repay the loan
in level annual payments over the customary term for the type of property
involved. In order for the usual risks and rewards of ownership to
be transferred, the institution cannot have substantial continuing
involvement with the property. ASC 360-20 provides detailed guidance
on the forms of continuing involvement that result in prohibition
on the use of the full accrual method.
Q26. What other accounting methods could apply to an institution-financed
sale of OREO? How are gains on sales and interest income recognized
under those methods?
A26. The following
methods are used when a sale has been consummated as prescribed by
GAAP, but the conditions for full accrual have not been met:
- Installment method: For use when the buyer’s
initial investment is not adequate for full accrual, but recovery
of the cost of the OREO asset is reasonably assured if the buyer defaults.
This method recognizes a sale of the OREO asset and the corresponding
new loan. Any gain on the sale is recognized as payments are received
and interest income may be accrued, when appropriate.
- Cost recovery method: For use when the disposition
does not qualify for full accrual or installment methods. This method
recognizes a sale of the OREO asset and the corresponding new loan
on nonaccrual status, and all income recognition is deferred. Principal
payments reduce the loan balance and interest increases unrecognized
gross profit. No gain or interest income is recognized until either
the aggregate payments exceed the recorded amount of the loan, or
a change to another accounting method is appropriate.
- Reduced-profit method: For use when the down
payment is adequate, but the amortization schedule does not meet full
accrual method requirements. This method recognizes a sale of the
OREO asset and a corresponding new loan. However, only a portion of
the gain on the sale is recognized as payments are received based
on the present value of the lowest level of periodic payments required
under the loan agreement.
If the transaction eventually meets the requirements
for the full accrual method, the institution may switch to that method
at that time and recognize any unrecognized gain on the sale. As stated
in Question 24, any loss on the sale of the OREO asset is recognized
immediately under all methods.
Q27. Under
what circumstances would an institution-financed sale of OREO not
result in a sale for accounting and reporting purposes, and what method
of accounting would be appropriate for the transaction?
A27. Under GAAP, certain conditions exist for a
sale to be consummated for accounting purposes (see Question 25).
If a sale is not consummated for accounting purposes, the transaction
is accounted for under the deposit method. Because there is no sale
for accounting purposes, the asset remains reported as an OREO asset
and no gain on sale or interest income for the new loan is recognized.
If, however, the net carrying amount of the OREO asset exceeds the
sum of the deposit received, the fair value of the unrecorded note
receivable, and the debt assumed by the buyer, the institution must
recognize the loss on the date the agreement to sell is signed. Payments
received from the borrower are reported as a liability until
sufficient payments have been received to qualify for a different
accounting method. The deposit method may also be used if a sale is
consummated for accounting purposes, but the initial investment is
inadequate and recovery of the cost of the property is not assured.
Finally, certain forms of continuing involvement in the
OREO asset by the institution may limit its ability to recognize a
sale. One example is when the institution may be required to initiate
or support operations for an extended period of time, which results
in accounting for the transaction as a financing, leasing, or profit-sharing
arrangement. One common type of condition that indicates a presumption
of support is when the institution holds a receivable from the buyer
for a significant part of the sales price and collection of the receivable
depends on the operation of the property. ASC 360-20 includes detailed
guidance on the types of continuing involvement that should be considered
when determining whether a sale has occurred for accounting and reporting
purposes.
Q28. May an institution sell
or transfer an OREO asset to a related party (such as the bank holding
company or a non-bank affiliate)?
A28. The
Federal Reserve does not have a regulation prohibiting the sale of
an OREO asset to a related party. When a transaction with a related
party occurs, an institution should verify that the asset is recorded
at fair value. The sale of an asset to an affiliate must comply with
the market terms requirement of the Board’s Regulation W (12
CFR 223.51). The terms must be substantially the same, or at least
as favorable to the institution, as those to nonaffiliates for comparable
transactions. Similarly, if an insider purchases an OREO asset, the
transaction must be recorded at fair value in accordance with GAAP
and not create a disadvantage to the institution by an artificially
low sales price. Additionally, the Board’s Regulation O (12
CFR 215) limitations apply when an institution finances an OREO asset
sale to an insider. Moreover, transfers of an OREO asset within a
holding company do not extend any period for the required divestiture
of the property. Refer to the Board’s Regulation Y (12 CFR 225.22(d)(1)(iii)).
Q29. What procedures and internal controls
should an institution have in place to assess the reasonableness of
an offer to purchase an OREO asset and to support the decision to
sell the property?
A29. The institution’s
procedures should ensure that the sale of an OREO asset maximizes
recovery and adheres to applicable federal and state laws and regulations.
The procedures should also address the approval process for the sale
of a particular property, including the level of management required
to approve a sale. Moreover, the procedures should address whether
the institution will consider an offer to purchase an OREO asset from
a related party (for example, a member of the board of directors,
an employee, or a relative of an employee).
Procedures should address documentation requirements for
the institution’s plans to market and sell the property, the
approval of the sale, and, if applicable, the approval of a loan to
finance the purchase of an OREO asset. Such documentation should include:
- A plan for the marketing and sale of the property
in accordance with applicable federal and state laws, including the
Fair Housing Act. The plan should be revised as needed to reflect
changes in market conditions;
- A record of inquiries and purchase offers made by
potential buyers, including reasons for rejecting an offer or accepting
an offer. Acceptance of an offer should include confirmation that
the potential buyer has the financial ability and motivation to close
the sale;
- Methods used to market, advertise, and sell the property,
whether by the institution or its agent (for example, documentation
should address the method of sale, including bulk sales or auction);
- The establishment of the property’s sales listing
price and any changes to the listing price;
- An assessment of market conditions affecting the
ability of the institution to sell the property, including regular
updates;
- Listing and sales agreements with the institution’s
agent, including terms of sales commissions;
- The purchase agreement and the terms of sale, including
any representations and warrants made by the institution, transaction
closing costs to be paid by the institution, and documentation on
the transfer of ownership and recordation of the title;
- Legal review of the sale transaction documents;
- Approval of the sale by the appropriate level of
management and, if applicable, the approval of the institution’s
loan to the purchaser of the property and executed loan documents;
- Confirmation of the institution’s receipt of
the funds from the purchaser of the property; and
- Other documentation related to the sale and transfer
of ownership, including cancellation or assignment of a property management
agreement, transfer of property management documents (for example,
lease agreements) to the new owner, and notification to the institution’s
insurance company of the sale.
Q30. What incentives exist to encourage
institutions to sell residential OREO properties to owner-occupants
and groups involved in neighborhood stabilization efforts, before
considering selling to investors?
A30. Many
institutions have implemented “first look” programs that
give prospective homeowners brief exclusive opportunity to purchase
bank-owned properties in certain neighborhoods so these homes can
either be rehabilitated, rented, resold, or demolished. Giving prospective
homeowners and communities a “first look” can help to
limit neighborhood blight, stabilize property values, maximize recovery,
and mitigate reputational risk for a financial institution.
Under the Community Reinvestment
Act (CRA) and the Neighborhood Stabilization Program rules, institutions
can receive investment credit for OREO donations made in U.S. Department
of Housing and Urban Development-designated Neighborhood Stabilization
Areas, in line with this provision of CRA.
Q31. What legal requirements should institutions consider when deciding
how to market and sell residential properties, including whether to
sell residential properties (or pools of properties) to investors
or at auction?
A31. An institution should
ensure that its policies and procedures governing the marketing, sale,
and disposition of OREO properties comply with applicable laws, including
the Fair Housing Act and the Equal Credit Opportunity Act (if the
institution makes or facilitates credit). For example, an institution’s
marketing and sales strategies may not be based on the racial or ethnic
composition of the geographies where the properties are located. Additionally,
when selling to investors, an institution should conduct proper due
diligence to ensure they have no prior criminal history and do not
engage in practices that could have an adverse impact on property
values. Institutions may also consider implementing controls to evaluate
purchaser actions following the sale of OREO property to an investor.
Some institutions now evaluate bulk purchasers to determine whether
properties are resold to responsible buyers or are contributing to
neighborhood blight due to negligence. Robust oversight of investor
purchase transactions of OREO properties can reduce an institution’s
financial, legal, and reputational risks.
Appendix GAAP Guidance on Minimum Initial Investment Requirements
As noted in ASC 360-20-40, a buyer’s initial
investment shall be adequate to demonstrate the buyer’s commitment
to pay for the property and shall indicate a reasonable likelihood
that the seller will collect the receivable. The minimum initial investment
requirements for various types of real estate are provided in ASC
360-20-55 (see the following table). The minimum initial investment
is expressed as a percentage of sales value. Although the table does
not cover every type of real estate property, an institution may make
analogies to the types and associated risks of properties specified
in this table to evaluate initial investments for other property types.
Further, institutions need to consider the other requirements
in ASC 360-20-55 to determine whether the institution needs to modify
the minimum initial investment requirement. If a recently placed permanent
loan or firm permanent loan commitment for maximum financing of the
property exists with an independent, established lending institution,
the minimum initial investment should be whichever of the following
is greater:
a. The minimum percentage
of sales value of the property specified in the ASC 360-20-55 table,
or
b. The lesser of:
1. The amount of the sales value of the property in excess of 115%
of the amount of a newly placed permanent loan or firm permanent loan
commitment from a primary lender that is an independent established
lending institution; or
2. 25% of the sales value.
Table from ASC
360-20-55
| Land |
Minimum Initial Investment Expressed as a Percentage of Sales Value |
| Held for commercial, industrial,
or residential development to commence within two years after sale |
20 |
| Held for commercial, industrial,
or residential development to commence after two years |
25 |
| Commercial and Industrial Property |
|
| Office and industrial buildings, shopping
centers, and so forth: |
|
| |
Properties subject to
lease on a long-term lease basis to parties with satisfactory credit
rating; cash flow currently sufficient to service all indebtedness |
10 |
| |
Single-tenancy properties
sold to a buyer with a satisfactory credit rating |
15 |
| |
All other |
20 |
| Other income-producing properties (hotels,
motels, marinas, mobile home parks, and so forth): |
|
| |
Cash flow currently
sufficient to service all indebtedness |
15 |
| |
Start-up situations
or current deficiencies in cash flow |
25 |
| Multifamily Residential Property |
|
| Primary residence: |
|
| |
Cash flow currently
sufficient to service all indebtedness |
10 |
| |
Start-up situations
or current deficiencies in cash flow |
15 |
| Secondary or recreational residence: |
|
| |
Cash flow currently
sufficient to service all indebtedness |
15 |
| |
Start-up situations
or current deficiencies in cash flow |
25 |
| Single-Family Residential Property (including condominium or cooperative
housing) |
|
| Primary residence of the buyer |
5(a) |
| Secondary or
recreational residence |
10(a) |
(a) If collectibility of the remaining portion of
the sales price cannot be supported by reliable evidence of collection
experience, the minimum initial investment shall be at least 60 percent
of the difference between the sales value and the financing available
from loans guaranteed by regulatory bodies such as the Federal Housing
Authority (FHA) or the Veterans Administration (VA), or from independent,
established lending institutions. This 60 percent test applies when
independent first-mortgage financing is not utilized and the seller
takes a receivable from the buyer for the difference between the sales
value and the initial investment. If independent first mortgage financing
is utilized, the adequacy of the initial investment on sales of single-family
residential property should be determined in accordance with ASC 360-20-55-1.
A seller of owner-occupied single-family residential homes
that finances a sale under an FHA or VA government-insured program
may use the normal down payment requirements or loan limits established
under those programs as a surrogate for the down payment criteria
set forth above and may record profit under the full accrual method,
provided that the mortgage receivable is fully insured from loss under
the FHA or VA program. In that specific circumstance, departure from
the minimum initial investment criteria above is justified because
all of the credit risk associated with the receivable from the sale
is transferred to the governmental agency. However, in all other circumstances
(for example, FHA or VA programs that provide for less than full insurance
or seller financing using private mortgage insurance), the minimum
initial investment criteria set forth above shall be followed.
Frequently asked questions of June 28, 2012 (SR-12-10).
